**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

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**FORM 10-Q**

**Mark One**

**x****Quarterly Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934 for the Quarterly Period Ended September 30, 2006.**

**or**

**o****Transition Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934 for the Transition Period From              To                ..**

**Commissionfile number:  000-25755**

**WORLDGATE COMMUNICATIONS, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

| **Delaware**              | ** ** | **23-2866697**                        |
|---------------------------|------------|---------------------------------------|
| (State of  Incorporation) |       | (I.R.S. Employer  Identification No.) |

 

**3190 Tremont Avenue**

**Trevose, Pennsylvania 19053**

(Address ofPrincipal Executive Offices)         (ZipCode)

**(215) 354-5100**

(Registrant’sTelephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes xNo o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer , or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o          Acceleratedfiler x          Non-acceleratedfiler o

Indicate by a check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

Yes oNo x

As of November 1, 2006,there were 40,443,190 shares of common stock, par value $.01 per share,outstanding.

 

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**WORLDGATECOMMUNICATIONS, INC.**

**QUARTERLYREPORT ON FORM 10-QFOR THE THREE MONTHS ENDED SEPTEMBER 30, 2006**

**TABLE OFCONTENTS**
| **PART I. FINANCIAL  INFORMATION** |                                                                                        |   |
|------------------------------------|---------------------------------------------------------------------------------------------|--------|
|                               |                                                                                        |   |
| Item 1.                            | Financial  Statements                                                                       | 3      |   |
| Item 2.                            | Management’s  Discussion And Analysis Of Financial Condition And Results Of Operations | 26     |   |
| Item 3.                            | Quantitative  And Qualitative Disclosures About Market Risk                                 | 31     |   |
| Item 4.                            | Controls And  Procedures                                                                    | 31     |   |
|                               |                                                                                        |   |
| **PART II. OTHER INFORMATION**     | ** **                                                                                  |   |
|                               |                                                                                        |   |
| Item 1.                            | Legal Proceedings                                                                           | 33     |   |
| Item 1A.                           | Risk Factors                                                                                | 33     |   |
| Item 2.                            | Unregistered  Sales Of Equity Securities And Use Of Proceeds                                | 34     |   |
| Item 3.                            | Defaults  Upon Senior Securities                                                            | 35     |   |
| Item 4.                            | Submission  Of Matters To A Vote Of Security Holders                                        | 35     |   |
| Item 5.                            | Other Information                                                                           | 35     |   |
| Item 6.                            | Exhibits                                                                                    | 35     |   |

 

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# **PART I.FINANCIAL INFORMATION**

# **ITEM1.  FINANCIAL STATEMENTS**

**WORLDGATECOMMUNICATIONS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS**

**(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)**
| ** **                                                                                                                                                                                      | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **(Unaudited)**              | ** ** | **(Audited)**               | ** ** |
| ASSETS                                                                                                                                                                                          |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                                 |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                      |       | $                            | 8,147      |                        | $          | 16,277 |   |
| Trade accounts  receivables                                                                                                                                                                     |       | 1,096                        |       | 133                         |       |
| Other  receivables                                                                                                                                                                              |       | 12                           |       | 26                          |       |
| Inventory, net                                                                                                                                                                                  |       | 1,907                        |       | 2,878                       |       |
| Prepaid and  other assets                                                                                                                                                                       |       | 329                          |       | 209                         |       |
| Total current  assets                                                                                                                                                                           |       | 11,491                       |       | 19,523                      |       |
|                                                                                                                                                                                            |       |                         |       |                        |       |
| Property and equipment                                                                                                                                                                          |       | 4,411                        |       | 4,084                       |       |
| Less:  accumulated depreciation and amortization                                                                                                                                                |       | (3,056                       | )          | (2,508                      | )          |
| Property and  equipment, net                                                                                                                                                                    |       | 1,355                        |       | 1,576                       |       |
| Deposits and other  assets                                                                                                                                                                      |       | 130                          |       | 130                         |       |
| Total assets                                                                                                                                                                                    |       | $                            | 12,976     |                        | $          | 21,229 |   |
|                                                                                                                                                                                            |       |                         |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIENCY                                                                                                                                                  |       |                         |       |                        |       |
| Current liabilities:                                                                                                                                                                            |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                |       | $                            | 639        |                        | $          | 1,695 |   |
| Accrued expenses                                                                                                                                                                                |       | 795                          |       | 1,333                       |       |
| Accrued  compensation and benefits                                                                                                                                                              |       | 162                          |       | 36                          |       |
| Convertible  debenture payable (net of unamortized discount of $5,799)                                                                                                                          |       | 1                            |       | 0                           |       |
| Dividend payable  on preferred stock                                                                                                                                                            |       | 2                            |       | 6                           |       |
| Detachable  Warrants                                                                                                                                                                            |       | 2,616                        |       | 1,038                       |       |
| Conversion  option on preferred stock                                                                                                                                                           |       | 23                           |       | 57                          |       |
| Conversion  option on convertible debt                                                                                                                                                          |       | 4,206                        |       | 0                           |       |
| Incentive sales  claims liability                                                                                                                                                               |       | 60                           |       | 278                         |       |
| Warranty reserve                                                                                                                                                                                |       | 83                           |       | 336                         |       |
| Deferred  revenues                                                                                                                                                                              |       | 243                          |       | 44                          |       |
| Returns reserve                                                                                                                                                                                 |       | 8                            |       | 2,310                       |       |
| Total current  liabilities                                                                                                                                                                      |       | 8,838                        |       | 7,133                       |       |
|                                                                                                                                                                                            |       |                         |       |                        |       |
| Commitments                                                                                                                                                                                     |       |                         |       |                        |       |
| Redeemable preferred  stock, $.01 par value, 7,550 shares authorized; 166 shares issued and  outstanding at September 30, 2006, and 500 shares issued and outstanding at  December 31, 2005     |       | 130                          |       | 379                         |       |
| Stockholders’ equity:                                                                                                                                                                      |       |                         |       |                        |       |
| Preferred Stock, $.01  par value, 13,492,450 shares authorized; 0 shares issued at September 30,  2006 and December 31, 2005                                                                    |       | 0                            |       | 0                           |       |
| Common Stock, $.01 par  value; 80,000,000 shares authorized; 40,218,345 shares issued and outstanding  at September 30, 2006 and 39,511,519 shares issued and outstanding at  December 31, 2005 |       | 402                          |       | 395                         |       |
| Additional paid-in  capital                                                                                                                                                                     |       | 244,124                      |       | 242,414                     |       |
| Accumulated deficit                                                                                                                                                                             |       | (240,518                     | )          | (229,092                    | )          |
| Total  stockholders’ equity                                                                                                                                                                |       | 4,008                        |       | 13,717                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                |       | $                            | 12,976     |                        | $          | 21,229 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated  financial statements.

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**WORLDGATECOMMUNICATIONS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

**(Dollarsin Thousands, Except per Share Amounts)**
| ** **                                                                                                                                                                                                                                                   | ** ** | **Three Months ended September 30,** | ** ** | **Nine Months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                   | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                                                                                   | ** ** | ** **                                               | ** ** | **(As restated)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Revenues                                                                                                                                                                                                                                                     |       | $                                                        | 962        |                                                    | $          | 2,290 |   | $ | 1,658 |   | $ | 3,866 |   |
| Cost of revenues                                                                                                                                                                                                                                             |       | 894                                                      |       | 2,450                                                   |       | 2,076 |   | 3,840 |   |
| Gross margins                                                                                                                                                                                                                                                |       | 68                                                       |       | (160                                                    | )          | (418 | ) | 26 |   |
| Engineering and  development (excluding depreciation and amortization amounts of $97 and $81  for the three months ended September 30, 2006 and 2005, respectively, and  $279 and $220 for the none months ended September 30, 2006 and 2005,  respectively) |       | 1,507                                                    |       | 1,242                                                   |       | 4,501 |   | 3,666 |   |
| Sales and  marketing (excluding depreciation and amortization amounts of $15 and $13 for  the three months ended September 30, 2006 and 2005, respectively, and $43 and  $31 for the nine months ended September 30, 2006 and 2005, respectively)            |       | 619                                                      |       | 392                                                     |       | 1,820 |   | 1,410 |   |
| General and  administrative (excluding depreciation and amortization amounts of $73 and  $82 for the three months ended September 30, 2006 and 2005, respectively, and  $226 and $267 for the nine months ended September 30, 2006 and 2005,  respectively)  |       | 1,205                                                    |       | 1,474                                                   |       | 5,573 |   | 3,462 |   |
| Depreciation and  amortization                                                                                                                                                                                                                               |       | 185                                                      |       | 176                                                     |       | 548 |   | 518 |   |
| Total expenses  from operations                                                                                                                                                                                                                              |       | 3,516                                                    |       | 3,284                                                   |       | 12,442 |   | 9,056 |   |
| Loss from  operating activities                                                                                                                                                                                                                              |       | (3,448                                                   | )          | (3,444                                                  | )          | (12,860 | ) | (9,030 | ) |
| Interest and  other income                                                                                                                                                                                                                                   |       | 90                                                       |       | 292                                                     |       | 323 |   | 466 |   |
| Change in fair  value of derivative warrants and conversion options                                                                                                                                                                                          |       | 17                                                       |       | 1,165                                                   |       | (322 | ) | 7,974 |   |
| (Loss) gain on  contract termination                                                                                                                                                                                                                         |       | (15                                                      | )          | 0                                                       |       | 1,777 |   | 0 |   |
| Amortization of  debt discount                                                                                                                                                                                                                               |       | (201                                                     | )          | 0                                                       |       | (201 | ) | 0 |   |
| Interest and  other expense                                                                                                                                                                                                                                  |       | (50                                                      | )          | (4                                                      | )          | (50 | ) | (6 | ) |
| Net loss                                                                                                                                                                                                                                                     |       | (3,607                                                   | )          | (1,991                                                  | )          | (11,333 | ) | (596 | ) |
| Accretion on  preferred stock, dividends and deemed dividends                                                                                                                                                                                                |       | 16                                                       |       | (656                                                    | )          | (92 | ) | (3,326 | ) |
| Net loss available  to common stockholders                                                                                                                                                                                                                   |       | $                                                        | (3,591     | )                                                       | $          | (2,647 | ) | $ | (11,425 | ) | $ | (3,922 | ) |
| Net loss per  common share:                                                                                                                                                                                                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | $                                                        | (0.09      | )                                                       | $          | (0.05 | ) | $ | (0.29 | ) | $ | (0.02 | ) |
| Fully Diluted                                                                                                                                                                                                                                                |       | $                                                        | (0.09      | )                                                       | $          | (0.05 | ) | $ | (0.29 | ) | $ | (0.02 | ) |
| Net loss  available to common stockholders per common share:                                                                                                                                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | $                                                        | (0.09      | )                                                       | $          | (0.07 | ) | $ | (0.29 | ) | $ | (0.11 | ) |
| Fully Diluted                                                                                                                                                                                                                                                |       | $                                                        | (0.09      | )                                                       | $          | (0.07 | ) | $ | (0.29 | ) | $ | (0.11 | ) |
| Weighted average  common shares outstanding:                                                                                                                                                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | 39,982,137                                               |       | 37,246,811                                              |       | 39,735,851 |   | 34,145,802 |   |
| Fully Diluted                                                                                                                                                                                                                                                |       | 39,982,137                                               |       | 37,246,811                                              |       | 39,735,851 |   | 34,145,802 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

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**WORLDGATECOMMUNICATIONS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in Thousands)**
| ** **                                                                   | ** ** | **Nine Months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | ** **                                          | ** ** | **(As restated)** | ** ** |
| Cash flows from  operating activities:                                       |       |                                                |       |   |   |
| Net loss                                                                     |       | $                                                   | (11,333    | ) | $ | (596 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                |       | 548                                                 |       | 518 |   |
| Amortization of debt discount                                                |       | 201                                                 |       | 0 |   |
| Change in fair value of derivative warrants and  conversion options          |       | 322                                                 |       | (7,974 | ) |
| Gain on contract termination                                                 |       | (1,777                                              | )          | 0 |   |
| Write down of inventory                                                      |       | 490                                                 |       | 0 |   |
| Non-cash stock based compensation                                            |       | 627                                                 |       | 2 |   |
| Changes in operating assets and liabilities:                                 |       |                                                |       |   |   |
| Trade accounts receivable                                                    |       | (963                                                | )          | (1,186 | ) |
| Other receivables                                                            |       | 14                                                  |       | (13 | ) |
| Inventory                                                                    |       | (366                                                | )          | (209 | ) |
| Prepaid and other assets                                                     |       | (120                                                | )          | (107 | ) |
| Accounts payable                                                             |       | (1,056                                              | )          | 1,011 |   |
| Accrued expenses                                                             |       | (329                                                | )          | 399 |   |
| Accrued compensation and benefits                                            |       | 126                                                 |       | (241 | ) |
| Warranty reserve                                                             |       | (20                                                 | )          | 0 |   |
| Deferred revenue                                                             |       | 199                                                 |       | (14 | ) |
| Net cash used in operating activities                                        |       | (13,437                                             | )          | (8,410 | ) |
|                                                                         |       |                                                |       |   |   |
| Cash flows from  investing activities:                                       |       |                                                |       |   |   |
| Capital expenditures                                                         |       | (327                                                | )          | (428 | ) |
| Net cash used in investing activities                                        |       | (327                                                | )          | (428 | ) |
|                                                                         |       |                                                |       |   |   |
| Cash flows from  financing activities:                                       |       |                                                |       |   |   |
| Payment of note payable                                                      |       | 0                                                   |       | (37 | ) |
| Proceeds from issuance of convertible debenture                              |       | 5,615                                               |       | 0 |   |
| Proceeds from issuance of common stock                                       |       | 19                                                  |       | 16,634 |   |
| Proceeds from the exercise of stock options                                  |       | 0                                                   |       | 818 |   |
| Proceeds from the exercise of stock rights and  warrants                     |       | 0                                                   |       | 1,474 |   |
| Net cash provided by financing activities                                    |       | 5,634                                               |       | 18,889 |   |
| Net (decrease)  increase in cash and cash equivalents                        |       | (8,130                                              | )          | 10,051 |   |
| Cash and cash  equivalents, beginning of period                              |       | 16,277                                              |       | 11,840 |   |
| Cash and cash  equivalents, end of period                                    |       | $                                                   | 8,147      |   | $ | 21,891 |   |
|                                                                         |       |                                                     |       |  |   |
| Cash paid for  interest                                                      |       | $                                                   | 0          |   | $ | 7 |   |
| Non-cash  financing activities:                                              |       |                                                |       |   |   |
| Conversion of preferred stock to common stock                                |       | $                                                   | 333        |   | $ | 5,775 |   |
| Conversion of convertible debenture to common stock                          |       | 200                                                 |       | 0 |   |
| Conversion of derivative liability                                           |       | 150                                                 |       | 0 |   |
| Accretion on preferred stock                                                 |       | 16                                                  |       | 462 |   |
| Dividends payable on preferred stock                                         |       | 2                                                   |       | 13 |   |
| Deemed dividend on conversion of preferred stock                             |       | 68                                                  |       | 0 |   |
| Common stock issued for accrued dividends                                    |       | 6                                                   |       | 197 |   |
| Issuance of note  payable to finance D&O insurance                       |       | 0                                                   |       | 230 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

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**WORLDGATECOMMUNICATIONS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(DollarAmounts are in Thousands, Except per Share Amounts)**

**(Unaudited)**

1.                                       Basisof Presentation.

The unaudited condensedconsolidated financial statements of WorldGate Communications, Inc. (“WorldGate”or the “Company”) for the three and nine months ended September 30, 2006 andSeptember 30, 2005 presented herein have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission forquarterly reports on Form 10-Q.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accord­ance with United States generally accepted accountingprinciples have been condensed or omitted pursuant to such rules andregulations.  These financial statementsshould be read in conjunction with the financial statements for the year endedDecember 31, 2005 and the notes thereto included in the Company’s Annual Reporton Form 10-K.

The financial informationin this Report reflects, in the opinion of management, all adjustments of anormal recurring nature necessary to present fairly the results for the interimperiod. Quarterly operating results are not necessarily indicative of theresults that may be expected for the year ending December 31, 2006.

2.                                       Reclassification

Certain reclassificationshave been made to the condensed consolidated financial statements shown for theprior period in order to have it conform to the current period’sclassifications.  The reclassificationshave no effect on previously reported losses.

In the current quarter wehave reclassified certain components of our stockholders’ equity section toreflect the elimination of deferred compensation arising from unvestedshare-based compensation pursuant to the requirements of Staff AccountingBulletin No. 107, regarding Statement of Financial Accounting Standards No.123(R), “Share-Based Payment.”  Thisdeferred compensation was previously recorded as an increase to additionalpaid-in capital with a corresponding reduction to stockholders’ equity for suchdeferred compensation.  Thisreclassification has no effect on net income or stockholders’ equity aspreviously reported.  The Company willrecord an increase to additional paid-in capital as the share-based paymentsvest.

3.                                       Liquidityand Going Concern Considerations.

As of September 30,2006 the Company had cash and cash equivalents of $8,147.  The operatingcash used in continuing operations for the three and nine months endedSeptember 30, 2006 was $4,629 and $13,437, respectively. 

In December 2003 andJanuary 2004, WorldGate received investments aggregating $3,100 fromcertain institutional investors. These investors purchased an aggregate of3,000,000 shares of newly issued common stock. The investors also received aright, for a limited period of time, to purchase additional shares of up to 20%of the common stock purchased by the investors in their investment, at the sameprice as their investment, and five-year warrants to purchase up to 30% of thecommon stock purchased by the investors in their investment, at an exerciseprice equal to a 25% premium to their purchase price for the investment. Thepurchase price for the 2,000,000 shares purchased in the December 2003transactions were $0.80 per share, with the warrants having a $1.00 per shareexercise price. The purchase price for the 1,000,000 shares purchased in theJanuary 2004 transaction was $1.50 per share, with the warrants having a$1.875 per share exercise price. All additional investment rights associatedwith the December 2003 transaction were exercised during January andFebruary of 2004, resulting in an incremental investment of $320. Alladditional investment rights associated with the January 2004 transactionwere exercised in May 2004, resulting in an incremental investment of$300. A portion of the warrants and additional investment right warrantsassociated with the December 2003 and January 2004 transactions wereexercised in December 2004 and January 2005, resulting in an incrementalinvestment of $925.

In December 2003,WorldGate reached agreement with Mototech, Inc. (“Mototech” is not anaffiliate of General Instruments or Motorola) for the purchase of 625,000shares of newly issued common stock at $0.80 per share, in return for futuredesign and engineering services by Mototech. WorldGate had previouslycontracted with Mototech to assist the

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Companywith the design and volume manufacture of WorldGate’s Ojo personal video phone.The purchase price for these shares has been fully paid as of December 31,2004 by an equivalent reduction in the development and initial procurementpayments that would otherwise be due to Mototech. The value of this transactionwas $600 (based on the closing stock price of $0.96 on the date of thetransaction) of which $200 was recorded as an expense for the year endedDecember 31, 2003 and $400 was expensed for the year ended December 31, 2004.In addition, in April 2004, Mototech invested $1,000 to purchase 666,666shares of newly issued common stock at $1.50 per share.

In June 2004 wecompleted a private placement of 7,550 shares of Series A Convertiblepreferred stock to certain institutional investors.  The shares were soldfor $1,000 per share, resulting in gross proceeds from the offering of $7,550.The preferred stock issued pursuant to this placement is convertible intoWorldGate common stock at a conversion price of $2.35 per share. WorldGate hasthe right to require conversion of the preferred stock into common stock uponachieving certain price targets with respect to its common stock and thesatisfaction of certain other conditions. Of the 7,550 convertible preferredissued, 500 shares remained outstanding as of December 31, 2005 and 166 sharesremain outstanding as of September 30, 2006. Between November 2004 and September 2006 all but one of theinvestors has fully converted their preferred shares resulting in the issuanceof 3,142,128 of our common shares. The preferred stock has a dividend rate of5% per annum, payable quarterly, which may be paid either by cash or throughthe issuance of common stock at WorldGate’s option (with stock payments beingmade at a 10% discount to the then current market price). Through September 30,2006, for all quarterly dividend payments due, WorldGate exercised its right tomake these dividend payments in stock, resulting in the issuance of anadditional 140,939 shares of our common stock. The preferred stock has a stagedmaturity over three years with scheduled payments of one third due after 18 months,one half of the remainder due after 24 months and the balance due after 36months. The preferred stock may be redeemed at maturity in cash or through theissuance of an indeterminate number of shares of common stock, at WorldGate’soption (subject to certain conditions). All dividend and maturity payments madein stock are subject to the satisfaction of certain conditions including thelisting and availability of an effective registration statement. As part of thetransaction, WorldGate issued five-year warrants to purchase a total of1,606,380 shares of WorldGate common stock, with one-half of the warrantshaving an exercise price of $2.69 per share and the remaining half having anexercise price of $3.14 per share. Through September 30, 2006, 125,000 ofthe $2.69 warrants have been exercised resulting in the issuance of anadditional 125,000 of our common shares and an additional $336 in grossproceeds; 51,915 of the $3.14 warrants have been exercised resulting in theissuance of an additional 51,915 of our common shares and an additional $163 ingross proceeds.  Based on anti-dilutionprovisions contained within this private placement the $2.69 warrants weremodified effective August 11, 2006 to an exercise price of $2.59 and the numberof outstanding warrants were increased by 25,975 as a result of a dilutivetransaction on this date related to the issuance of convertible debentures andwarrants.  These warrants were furthermodified effective October 13, 2006 to an exercise price of $2.52 and the numberof outstanding warrants was further increased by 19,506 as a result of adilutive transaction on this date also related to the issuance of convertibledebentures and warrants.   Based onanti-dilution provisions contained within this private placement the $3.14warrants were also modified effective August 11, 2006 to an exercise price of$3.01 and the number of outstanding warrants were increased by 31,629 as aresult of a dilutive transaction on this date related to the issuance ofconvertible debentures and warrants. These warrants were further modified effective October 13, 2006 to anexercise price of $2.92 and the number of outstanding warrants was furtherincreased by 24,192 as a result of a dilutive transaction on this date alsorelated to the issuance of convertible debentures and warrants.   The investors also received an additionalinvestment right, for a limited period of time, to purchase 1,606,380additional common shares at $3.14 a share. During December 2004, all butone of the investors exercised their additional investment rights resulting inthe issuance of an additional 1,500,000 shares and an additional $4,710 ingross proceeds. During the first quarter of 2005, the remaining investorexercised its additional investment right resulting in the issuance of anadditional 106,383 shares and an additional $334 in gross proceeds. The privateplacement includes numerous provisions intended to protect these institutionalinvestors including a cash payment penalty of 1.0% per month for unredeemed preferredshares once registration of the shares lapse and until the registration againbecomes effective. 

In December 2004,WorldGate completed a private placement of 208,333 shares of its common stockto K. Y. Chou, President and General Manager of Mototech, at a sales price of$2.40 per share, which resulted in additional gross proceeds to the Company of$500.  In connection with this placement the Company granted warrants toMr. Chou to purchase up to 62,500 shares of common stock at an exerciseprice of $2.88 per share.

In August 2005, theCompany completed a private placement of $17,500 of its common stock andwarrants with several institutional investors. The Company issued 4,666,664shares of its common stock at $3.75 per share to the participating investors.The Company also issued five-year warrants to purchase a total of 1,671,947shares of its common stock: 1,633,333 shares to the investors at an exerciseprice of $5.00 per share, and 38,614 shares to the placement agent at anexercise price of $4.53 per share. The investors also received anadditional investment right, for a period of 60 days from the time the sharesbecome registered, to purchase 1,554,000 additional shares of common stock at$4.12 per share. The accounting for these warrants and investment rights isestablished by analogy to Accounting Principle Board Opinion (“APB”)No. 14 “Accounting for Convertible Debt and Debt Issued with StockPurchase Warrants,” which addresses detachable stock

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purchasewarrants issued in conjunction with convertible debt and prescribes that suchwarrants be accounted for as additional paid in capital measured at fair value.The private placement includes numerous provisions intended to protect theseinstitutional investors including a cash payment penalty of 1.5% per month forthe period above 120 days from the effective date of the agreement that theshares in the transaction fail to be registered. The Registration Statementcovering the shares under this private placement was not declared effective untilJune 1, 2006.  Until such time as theshares were registered the Company was subject to the penalty provision underthis private placement. For the three months ended September 30, 2006 and 2005the Company recorded and expensed related penalties of $0 and $0,respectively.  For the nine months endedSeptember 30, 2006 and 2005 the Company recorded and expensed related penaltiesof $1,387 and $0, respectively. The related unpaid penalties accrued as ofSeptember 30, 2006 and December 31, 2005 were $472 and $525, respectively.   OnJuly 25, 2006, the Company amended the terms of the additional investment rightthat was granted to an investor as part of the August 2005 private placement,with respect to a portion of shares of common stock purchasable thereunder andagreed to apply $158 of accrued penalties towards the exercise price of suchamended additional investment right, for the purchase of 129,950 shares ofcommon stock. The penalties had accrued with respect to the Company’s inabilityto register the shares acquired by such investor in the private placementwithin 120 days of the transaction.  Inconsideration for this amendment and application of the exercise proceeds theinvestor agreed to forego any cash payment of the penalties other than asavailable through the proceeds of the exercise of the amended investment rightand to grant to the Company a release of all claims relating to the lateregistration of the private placement shares, other than the aforesaidpenalties.  The amended additional investment right provides that theinvestor thereof may purchase the 129,950 shares of common stock for a periodof 760 days beginning June 1, 2006 for an exercise price of $1.515 pershare.  The terms of the additional investment rights with respect to theremaining 1,424,050 shares of common stock purchasable thereunder remainunchanged.  On July 26, 2006 thisinvestor exercised the additional investment right for 129,950 shares. OnJuly 31, 2006 the amended additional investment right with respect to the remaining1,424,050 shares of common stock expired.

Registration statementsfor the securities sold pursuant to the June 2004, December 2004 and August2005 private placements were originally filed containing financial statementsthat were current at the time of the filing. Subsequently, the Companyinitiated a process to amend, restate, and re-file certain of its 2003, 2004and 2005 financial statements to correct an error in the accounting treatmentfor various security components of our private placements. As a result theregistration statements then on file also needed to be amended to reflect thesechanges in our financial statements. Amended registration statements weresubsequently filed with the SEC to reflect the amended and restated financialstatements, and became effective on June 1, 2006.

On August 11, 2006 theCompany completed a private placement with an institutional investor of aconvertible debenture in the aggregate principal amount of up to $11,000.  This convertible debenture has a maturity ofthree years, an interest rate of 6% per annum, and is convertible at the optionof the investors into WorldGate common stock at a conversion price equal to thelesser of $1.75 per share or 90% of the average of the five lowest daily volumeweighted average closing price (“VWAP”) of the common stock during the fifteentrading days immediately preceding the conversion date (subject to adjustmentin the event of stock dividends and splits and certain distributions tostockholders, fundamental transactions, and future dilutive equitytransactions).  Interest is payable at maturity, and the Company may electto pay the interest amount in cash or shares of our common stock. ThroughSeptember 30, 2006 the investors converted $200 of the convertible debt into142,814 shares of the Company’s common stock.. In October 2006, the investorsconverted an additional $250 of the convertible debt into199,042 shares of theCompany’s common stock.  On November 7,2006 the investors converted an additional $200 of the convertible debt into184,553 shares of the Company’s common stock.

The Company received$6,000 upon the closing of the transaction ($5,615, net of transaction costs)and the remaining $5,000 ($4,700, net of transaction costs) was received onOctober 13, 2006 after receiving stockholder approval on October 11, 2006 andobtaining an effective registration of the shares of common stock issued andissuable upon conversion of the debenture in the first tranche of thistransaction.

The Company has the rightto redeem all or any portion of the principal amount of the convertibledebentures in cash at any time upon not less than four business days notice ifthe closing price of our stock is less than $1.75 per share.  Such earlyredemption will, however, require us to pay a 10% prepaymentpremium.   In addition, without any prepayment premium, the Companyhas the right to force the holders to convert a maximum of $500 of theprincipal amount of the convertible debentures in any thirty day period if forfive consecutive trading days the VWAP of our common stock is above $1.925 pershare but less then $3.50 per share and providing the daily trading volumeexceeds 200,000 shares for these five days, and certain other conditions aremet.  If the VWAP of our common stock isgreater than $3.50 per share for 30 consecutive trading days, the daily tradingvolume exceeds 250,000 shares for five days prior, and if certain otherconditions are met, the Company can also force the holder to convert all or anyportion of the outstanding principal and interest into shares of our commonstock without any prepayment premium.

8

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There are somerestrictions on the holder’s right to convert the convertible debentures. The holder cannot make any conversions below $1.75 per share (i) until the earlierof the date registered common stock can be issued pursuant to such conversionor January 1, 2007, (ii) which would exceed $500 in principal amount in anycalendar month, or (iii) which would result in the issuance of more than840,000 shares of our common stock per calendar month (provided that thismaximum share limit will be waived by the Company unless it elects to pay theholder in cash the difference in value between 840,000 shares and the number ofshares the holders wishes to convert, up to the $500 per month conversionlimit).  If the Company is in default under the convertible debenturethese limitations are waived. The holder is also not restricted in makingconversions at $1.75.  In no case,however may the holder convert the convertible debentures if (x) it wouldresult in beneficial ownership of more than 9.99% of our outstanding commonstock (though this provision can be waived by the holder upon 65 days priornotice), or (y) such conversion would, without stockholder approval, cause theCompany to issue more than 19.99% of its outstanding shares as determinedimmediately prior to consummation of the transaction.  Under certaincircumstances, the convertible debenture holders are entitled to have theconversion price adjusted to correspond to common stock holders’ rights to anystock dividend, stock split, stock combination or reclassification of shares.The $1.75 conversion price is also subject to a weighted average dilutionadjustment if the Company issues shares (apart from certain excluded issuances)of our capital stock at an effective price of less than $1.75 per share. The Company also granted the convertible debentures holders a security interestin all of our assets.  Moreover, theCompany is required to register the shares of common stock issuable to theinvestor for resale to the public pursuant to a registration rights agreement,containing customary terms, conditions and indemnities.  The private placement includes numerousprovisions intended to protect the institutional investors including a cashpayment penalty of 1.0% per month for the period above 120 days from theeffective date of the agreement that the shares in the transaction fail to beregistered with the aggregate penalty capped at 12%.

In addition, theaggregate number of shares to be issued upon conversion, exercise of thewarrants, payment for commitment shares, and payment of liquidated damagespursuant to the registration rights agreement has been limited to 61,111,111shares of common stock.  

As part of this privateplacement the Company issued  five-yearwarrants to purchase a total of up to 2,595,000 shares of WorldGate commonstock, with 1,145,000 of the warrants having an exercise price of $1.85 pershare (with 624,545 of these warrants issued at the initial closing and 520,455warrants issued at the closing of the second tranche of funding), 1,100,000 ofthe shares having an exercise price of $2.35 per share (with 600,000 of thesewarrants issued at the initial closing and 500,000 warrants issued at the closingof the second tranche of funding), and 350,000 warrants having an exerciseprice of $2.60 per share (with 190,909 of these warrants issued at the initialclosing and 159,091 warrants issued at the closing of the second tranche offunding).

On April 28, 2004,the Company entered into a multi-year agreement with General InstrumentCorporation d/b/a the Connected Home Solutions Business of Motorola, Inc.(“General Instrument”) for the worldwide development and distribution of theOjo personal video phone. This agreement provided for General Instrument to beWorldGate’s exclusive distributor of its broadband video phone products and forWorldGate to be General Instrument’s exclusive supplier of its broadband videophone products.  On February 17, 2006,the Company mutually agreed with General Instrument to end this agreement.  The ending of this agreement immediatelyterminates exclusivity for both parties. In addition to its current role fordevelopment and manufacture of Ojo, WorldGate will now have direct responsibilityand control for the advertising, marketing, and distribution of itsproducts.   Under its agreement with General Instrument, WorldGatehad been active in marketing and promoting its products, and working withGeneral Instrument to distribute Ojo. WorldGate continued the rollout of Ojousing many of the same distributors, retailers and service providers, and plansto expand distribution to service providers and retailers around theworld.  The two companies will work together to ensure a smooth transitionfor customer accounts.  As part of endingits agreement with General Instrument, and in anticipation of WorldGateinventory requirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the same inventoryfrom its manufacturing sources.  As aresult, the Company recorded a reserve for returns and reduced revenue in theamount of approximately $2,310 during the fourth quarter of 2005. In addition,the Company has recorded no revenue for units shipped to General Instrument inthe first quarter 2006 and has recorded a gain on termination of this agreementof approximately $1,777 during the first quarter 2006 as a result of the lowerpurchase price of the inventory repurchased from General Instrument ($1,327,net of the cost of rework for rebranding the product and the adjustment of theinventory to its current replacement value) and reversal of  the product refund program reserve ($212) aswell as an adjustment of the warranty reserve for products repurchased ($233),both of which resulted from the termination of the Company’s agreement withGeneral Instrument.

The Company had $8,838 ofliabilities and its assets are pledged as collateral as of September 30,2006. These liabilities include $1,119 of dividends, detachable warrants andconversion options related to the Company’s private placement

9

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ofpreferred stock in June 2004 and $5,729 of debt and conversion options relatedto the Company’s financing in August 2006.

Our short term cashrequirements and obligations include, inventory, accounts payable and capitalexpenditures from continuing operations, operating expenses, and the redemptionof preferred stock, of which $166 is required to be redeemed in June 2007,although this redemption can be made in common stock if certain conditions aremet.  In addition, the August 2005private placement includes cash payment penalties of 1.5% per month for theperiod that the shares in the transaction fail to be registered. TheRegistration Statement covering the shares under this private placement was notdeclared effective until June 1, 2006. Until such time as the shares wereregistered the Company was subject to the penalty provision under this privateplacement. For the three months ended September 30, 2006 and 2005 the Companyrecorded and expensed related penalties of $0 and $0, respectively.  For the nine months ended September 30, 2006and 2005 the Company recorded and expensed related penalties of $1,387 and $0,respectively. The related unpaid penalties accrued as of September 30, 2006 andDecember 31, 2005 were $472 and $525, respectively.  

Management expects, basedon our internal forecasts and assumptions, including, among others, assumptionsregarding our short term cash requirements and our projected revenue growth,and including the full funding of $11,000 from the August 11, 2006 transactioncompleted subsequent to stockholder approval received on October 13, 2006, thatthe Company has sufficient cash on hand to meet its obligations into the secondhalf of 2007.

The Company’s ability togenerate cash is dependent upon the sale of Ojo products and on obtaining cashthrough capital markets. The Company began generating revenue fromcommercial shipment of the Ojo product in April 2005.  Initially all product sales were conductedthrough General Instrument, our exclusive distributor and all revenue was basedupon sales of our products to General Instrument for their distribution toresellers.  In February 2006, our distributorrelationship with General Instrument was ended and the Company began todirectly distribute and sell our products. This transition process, including forming direct relationships with theresellers and adding incremental distribution resulted in a delay in ourongoing sales and a decrease in revenue from the first nine months of 2006versus the same period in 2005.  As theCompany completes its transition activities it expects revenues to increase asit continues to roll out our products to the marketplace. Depending on the rampup of sales and the achievable margin, the increased level of sales activityshould have a positive impact on our cash flows from operations, which willsupport our ability to meet our cash requirements in the long term. Given thatthe video phone business involves the development of a new product line with nomarket penetration, in an underdeveloped market sector, no assurances can begiven that sufficient sales, if any, will materialize.

Additionally, if and asneeded, the Company plans to generate cash by turning to the capital marketsfor further funding.  No assurances can be given that, if pursued,additional financing transactions can be consummated.  The Companycontinues to evaluate possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources, should the Company need to obtain suchfinancing.  Such additional financing would be subject to the risk ofavailability, may be dilutive to our stockholders, or could impose restrictionson operating activities. There can be no assurance that this additionalfinancing will be available on terms acceptable to the Company, if at all.

Long term cashrequirement obligations are primarily related to the June 2004 and the August2006 transactions. The Company has long term debt as of September 30, 2006 onthe balance sheet reflecting the convertible debenture issued on August 11,2006.   The Company has limited capacity to reduce its workforce and scaleback on capital and operational expenditures to decrease our cash usage.

4.                                       Restatement September 2005

The Company has restatedits financial statements for the quarter ended September 30, 2005 to correctthe accounting for certain conversions of preferred stock related to its June2004 private placement of 7,550 shares of Series A Convertible Preferredstock to certain institutional investors. The corrected accounting reclassifiesthe converted preferred stock and the associated conversion options liabilityto equity based on a ratio of the shares converted during the quarter to thetotal preferred shares outstanding, whereas previously the ratio used for thereclassification of preferred stock and conversion options was based on thepercentage of these instruments to each other and applied to the amountconverted. In addition, both the fair value of the conversion option and anyunaccreted discount associated with the conversion are being applied to equitywith the discount being accounted for as a deemed dividend which is alsopresented in the statement of operations. We previously did not reflect the discount on the preferred stock as adeemed dividend.  There is no cash impactassociated with these restatements. 

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The effect of therestatement on specific amounts provided in the consolidated financialstatements is as follows:
| ** **                               | ** ** | **September 30, 2005** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| **Consolidated Balance Sheet** | ** ** | **As previously  reported** | ** ** | **As restated** | ** ** |
|                                     |       |                             |       |   |   |
| Redeemable Preferred Stock               |       | $                                | 702        |   | $ | 678 |   |
|                                     |       |                             |       |   |   |
| Accumulated deficit                      |       | $                                | (218,207   | ) | $ | (219,372 | ) |
| Additional-paid-in capital               |       | 237,256                          |       | 238,445 |   |
| Total stockholders’ deficiency      |       | 19,442                           |       | 19,466 |   |

 
|                                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                            | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| **Consolidated Statement of  Operations**                   | ** ** | **As previously  reported** | ** ** | **As restated**             | ** ** | **As previously  reported** | ** ** | **As restated** | ** ** |
|                                                                  |       |                             |       |                             |       |   |   |   |   |
| Change in fair value of derivative warrants and  conversion options   |       | $                                | 1,759      |                             | $          | 1,165 |   | $ | 9,401 |   | $ | 7,974 |   |
| Loss from operations                                                  |       | (1,397                           | )          | (1,991                           | )          | 831 |   | (596 | ) |
| Net loss                                                              |       | (1,397                           | )          | (1,991                           | )          | 831 |   | (596 | ) |
| Accretion preferred stock and dividends                               |       | (85                              | )          | (656                             | )          | (719 | ) | (3,326 | ) |
| Net (loss) available to common stockholders                           |       | (1,482                           | )          | (2,647                           | )          | 112 |   | (3,922 | ) |
|                                                                  |       |                             |       |                             |       |   |   |   |   |
| Net (loss) income per common share:                                   |       |                             |       |                             |       |   |   |   |   |
| Basic                                                                 |       | $                                | (0.04      | )                                | $          | (0.05 | ) | $ | 0.02 |   | $ | (0.02 | ) |
| Diluted                                                               |       | (0.04                            | )          | (0.05                            | )          | 0.02 |   | (0.02 | ) |
| Net (loss) income available to common shareholders  per common share: |       |                             |       |                             |       |   |   |   |   |
| Basic                                                                 |       | $                                | (0.04      | )                                | $          | (0.07 | ) | $ | 0.00 |   | $ | (0.11 | ) |
| Diluted                                                               |       | (0.04                            | )          | (0.07                            | )          | 0.00 |   | (0.11 | ) |

 

5.                                       RecentAccounting Pronouncement.

In November 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 151 “Inventory Costs” which amends theguidance in ARB No. 43, Chapter 4 “Inventory Pricing,” to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). ARB 43 previously stated that under somecircumstances, items such as idle facility expense, excessive spoilage, doublefreight, and rehandling costs may be so abnormal as to require treatment ascurrent period charges.” SFAS No. 151 requires that those items berecognized as current period charges regardless of whether they meet thecriterion of “so abnormal.” In addition, SFAS No. 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. SFAS No. 151 iseffective for inventory costs incurred during fiscal years beginning afterJune 15, 2005. Earlier application is permitted for inventory costsincurred during fiscal years beginning after the date SFAS No. 151 wasissued. SFAS No. 151 shall be applied prospectively. The adoption of SFASNo. 151 has not materially effected the Company’s condensed consolidatedfinancial statements.

In December 2004,the FASB issued SFAS No. 123 (R), “Share-Based Payment” that focusesprimarily on accounting for transactions in which an entity obtains employeeservices in share-based payment transactions. This statement replaces SFASNo. 123, “Accounting for Stock-Based Compensation,” and supersedes APBOpinion No. 25, “Accounting for Stock Issued to Employees.”  In March 2005, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 107

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(“SAB107”) relating to the adoption of SFAS 123R. SAB 107 primarily interprets how the implementation of SFAS 123R is tobe applied under SEC rules and regulations. Beginning January 1, 2006, theCompany is required to expense the fair value of employee stock options andsimilar awards. The Company has elected to utilize the modified prospectivetransitional method in accounting for share-based employee paymenttransactions. Based upon the employee options outstanding as of September 30,2006, and the transitional provisions of SFAS No.123R and SAB 107, there areapproximately $1,454 of future costs, utilizing the fair value method that willbe expensed over a four year period from 2006 through 2010.  Additionally, the Company will utilize thefair value method for any future instruments issued after January 1, 2006 (formore details, refer to Note 7).

In March 2005, theFASB issued Interpretation No. 47 (FIN 47) to clarify the guidanceincluded in SFAS No. 143, “Accounting for Asset Retirement Obligations.”  FIN 47 requires companies to recognize aliability for the fair value of a legal obligation to perform asset retirementactivities that are conditional on a future event if the amount can bereasonably estimated.  If amounts cannot be reasonably estimated, certaindisclosures will be required about the unrecognized asset retirementobligations.  The adoption of FIN 47 didnot have a material effect on the Company’s condensed consolidated financialposition or results of operations.

In May 2005, SFASNo. 154, “Accounting Changes and Error Corrections – replacement of APBOpinion No. 20 and FASB Statement No. 3,” was issued. SFASNo. 154 changes the accounting for and reporting of a change in accountingprinciple by requiring retrospective application to prior periods’ financialstatements of changes in accounting principle unless impracticable. SFASNo. 154 is effective for accounting changes made in fiscal years beginningafter December 15, 2005. The adoption of SFAS No. 154 did not have amaterial impact on the Company’s condensed consolidated results of operations,financial position or cash flows.

In June 2005, the EITFreached consensus on Issue No. 05-2, “The Meaning of  Conventional Convertible Debt Instrument’ inEITF Issue No. 00-19, ‘Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in, a Company’s Own Stock.’“ Issue 00-19 is used toevaluate whether embedded derivatives should be bifurcated under SFAS No. 133, “AccountingFor Derivative Instruments and Hedging Activities,” as amended. Specifically,SFAS No.133 provides guidance as to when an issuer is required to bifurcate aconversion option that is embedded in convertible debt. However, Issue 00-19does not define “conventional convertible debt instrument.” Given thedevelopment of numerous contractual terms that may be included in a convertibledebt instrument, it is not clear when a convertible debt instrument is “conventional.”  The Company does not believe that ourredeemable preferred stock and related warrants meet the definition ofconventional convertible debt and as a result Issue No. 00-19 applies to theliability treatment of these instruments. The adoption of the Issue did not have an effect on the Company’scondensed consolidated financial position or results of operations.

In September 2005, theEITF reached consensus on Issue No. 04-13, “*Accounting for Purchases and Sales of Inventory with the SameCounterparty,”*that inventory purchases and sales transactions withthe same counterparty that are entered into in contemplation of one another shouldbe combined for purposes of applying APB Opinion No. 29, “*Accounting for Nonmonetary Transactions.”* The effect reduces reported revenues and costof sales for affected transactions. The consensus on this issue applies to suchtransactions beginning in the first quarter 2006.   The adoption of Issue No. 04-13 did not havea material effect on the Company’s condensed consolidated financial position orresults of operations.

In September 2005, theFASB ratified the EITF Issue No. 05-7, “Accounting for Modifications toConversion Options Embedded in Debt Instruments and Related Issues,” whichaddresses whether a modification to a conversion option that changes its fairvalue effects the recognition of interest expense for the associated debtinstrument after the modification, and whether a borrower should recognize abeneficial conversion feature, not a debt extinguishment, if a debtmodification increases the intrinsic value of the debt (for example, themodification reduces the conversion price of the debt). The adoption of theIssue did not have a material effect on our condensed consolidated financialposition or results of operations.

In September 2005, theFASB also ratified the EITF’s Issue No. 05-8, “Income Tax Consequences ofIssuing Convertible Debt with a Beneficial Conversion Feature,” which discusseswhether the issuance of convertible debt with a beneficial conversion featureresults in a basis difference arising from the intrinsic value of thebeneficial conversion feature on the commitment date (which is  recorded in the stockholder’s equity for bookpurposes, but as a liability for income tax purposes) and, if so, whether thatbasis difference is a temporary difference under SFAS No. 109, “Accounting forIncome Taxes.”  The adoption of the Issuedid not have a material effect on the Company’s condensed consolidatedfinancial position or results of operations.

In February 2006, theFASB issued SFAS No. 155 ‘‘Accounting for Certain Hybrid Financial Instruments,an amendment of FASB Statements No. 133 and 140’’ (‘‘SFAS 155’’). SFAS 155clarifies certain issues relating to embedded derivatives and beneficialinterests in securitized financial assets. The provisions of SFAS 155 areeffective for all financial

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instruments acquired or issued after fiscal yearsbeginning after September 15, 2006. The Company is currently assessing theimpact that the adoption of SFAS 155 will have on its results of condensedconsolidated operations and financial position.

In March 2006, the FASB issued SFAS No. 156,“Accounting for Servicing of Financial Assets” (“SFAS 156”), whichamends SFAS 140, “Accounting for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities,” with respect to the accounting for separatelyrecognized servicing assets and servicing liabilities. SFAS 156 permitsthe choice of the amortization method or the fair value measurement method,with changes in fair value recorded in income, for the subsequent measurementfor each class of separately recognized servicing assets and servicingliabilities. The statement is effective for years beginning afterSeptember 15, 2006, with earlier adoption permitted. The Company iscurrently evaluating the effect that adopting this statement willhave on the Company’s financial position and results of operations.

In June 2006, the FASB issued InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). Thisinterpretation clarified the accounting for uncertainty in income taxesrecognized in accordance with FASB Statement No. 109, “Accounting forIncome Taxes” (SFAS No. 109). Specifically, FIN 48 clarifies theapplication of SFAS No. 109 by defining a criterion that an individual taxposition must meet for any part of the benefit of that position to berecognized in an enterprise’s financial statements. Additionally, FIN 48provides guidance on measurement, derecognition, classification, interest andpenalties, accounting in interim periods of income taxes, as well as therequired disclosure and transition. This interpretation is effective for fiscalyears beginning after December 15, 2006. The Company is currentlyevaluating what effects the adoption of FIN 48 will have a on the Company’scondensed consolidated financial position and results of operations.

In September 2006, the FASB issued Statement ofFinancial Accounting Standard 157 “Fair Value Measurements”, which defines fairvalue, establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair valuemeasurements.  Adoption is required for fiscal years beginning afterNovember 15, 2007, and interim periods within those fiscal years.  Earlyadoption of SFAS 157 is encouraged.  The Company is currently evaluatingthe expected effect of SFAS 157 on its consolidated financial statements and iscurrently not yet in a position to determine such effects.

In September 2006, the staff of the Securities andExchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”) whichprovides interpretive guidance on how the effects of the carryover or reversalof prior year misstatements should be considered in quantifying a current yearmisstatement.  SAB 108 becomes effectivein fiscal 2007.  Adoption of SAB 108 isnot expected to have a material impact on the Company’s consolidated financialposition, results of operations or cash flows.

6.                                       Inventories.

The Company’s inventory as carried in its financialstatements is all finished goods inventory. The Company orders, purchases and receives finished, completed, boxedand ready for sale video phone products directly from its supplier.  The Company makes no subsequent changes tothe products.  The Company does notmaintain work in process inventory, component raw materials or supplies, exceptfor very minimal quantities for repair work. The Company does not include tooling, deferred start-up or general andadministrative costs in its inventory costs. The Company also does not maintain specific inventory for any specificlong-term contracts or programs.  TheCompany tracks and removes inventory only under the “first-in, first-out method”and prices it based upon the Company’s actual cost unless adjustments arerequired for obsolescence or for market valuations.  During the three and nine months endedSeptember 30, 2006, the Company reduced inventory by $0 and $490, respectively,for such adjustments.

Inventories as ofSeptember 30, 2006 and December 31, 2005 are summarized as follows:
|                 | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw material    |       | $                            | 0          |                        | $          | 0 |   |
| Finished goods  |       | 1,907                        |       | 2,878                       |       |
| Total Inventory |       | $                            | 1,907      |                        | $          | 2,878 |   |

 

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7.                                       Stock Based Compensation.

Effective January 1, 2006, the Company adopted thefair value recognition provisions of SFAS No. 123 (Revised 2004), “Share-BasedPayment,” using the modified-prospective-transition method. As a result, theCompany’s net loss before taxes for the three and nine months ended September30, 2006 is approximately $199 ($0.01 per share), and $615 ($0.02 per share),respectively, greater than if it had continued to account for share-basedcompensation under APB Opinion No. 25 “Accounting for Stock Issued toEmployees.”  The stock based compensationexpense is included in general and administrative expense in the condensedconsolidated statement of operations.

Prior to January 1, 2006, the Company’s stock-basedemployee compensation plans were accounted for under the recognition andmeasurement provisions of  APB No. 25,and related Interpretations, as permitted by FASB Statement No. 123, “Accountingfor Stock-Based Compensation.”  TheCompany did not recognize stock-based compensation cost in its statement ofoperations for periods prior to January 1, 2006 as all options granted had anexercise price equal to the market value of the underlying common stock on thedate of grant. However, compensation expense was recognized for certain optionsgranted to non employees of the Company based upon fair value.

As was permitted under SFAS No. 148, “Accounting forStock-Based Compensation - Transition and Disclosure,” which amended SFAS No.123, the Company elected to continue to follow the intrinsic value method inaccounting for its stock-based employee compensation arrangements as defined byAPB No. 25, and related interpretations including FASB Interpretation No. 44, “Accountingfor Certain Transactions Involving Stock Compensation,” an interpretation ofAPB No. 25. No stock-based employee compensation cost is reflected inoperations, as all options granted under those plans had an exercise priceequal to the market value of the underlying common stock on the date of grant.The following table illustrates the effect on net (loss) income and net (loss)income per share as if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based employee compensation:
|                                                                                                                              | ** ** | **Three Months  Ended September  30, 2005** | ** ** | **Nine Months  Ended September  30, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **(As restated)**                                     | ** ** | **(As restated)**                                    | ** ** |
| Net loss, as  reported                                                                                                       |       | $                                                          | (1,991     | )                                                         | $          | (596 | ) |
|                                                                                                                         |       |                                                       |       |                                                      |       |
| Less:  Stock-based employee compensation expense determined under fair value-based  method for all awards, net of income tax |       | (215                                                       | )          | (615                                                      | )          |
| Pro forma net  loss                                                                                                          |       | $                                                          | (2,206     | )                                                         | $          | (1,211 | ) |
|                                                                                                                         |       |                                                       |       |                                                      |       |
| Net loss per  share:                                                                                                         |       |                                                       |       |                                                      |       |
|                                                                                                                         |       |                                                       |       |                                                      |       |
| Net loss - as  reported:                                                                                                     |       |                                                       |       |                                                      |       |
| Basic                                                                                                                        |       | $                                                          | (0.05      | )                                                         | $          | (0.02 | ) |
|                                                                                                                         |       |                                                       |       |                                                      |       |
| Fully Diluted                                                                                                                |       | $                                                          | (0.05      | )                                                         | $          | (0.02 | ) |
|                                                                                                                         |       |                                                       |       |                                                      |       |
| Net loss – pro  forma:                                                                                                  |       |                                                       |       |                                                      |       |
| Basic                                                                                                                        |       | $                                                          | (0.06      | )                                                         | $          | (0.04 | ) |
|                                                                                                                         |       |                                                       |       |                                                      |       |
| Fully Diluted                                                                                                                |       | $                                                          | (0.06      | )                                                         | $          | (0.04 | ) |

 

A summary of the Company’s stock plan is presentedbelow:
| ** **                           | ** ** | **Stock Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Aggregate Intrinsic  Value** | ** ** |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | ** **             | ** ** | ** **                                | ** ** | **(in thousands)**             | ** ** |
| Outstanding,  December 31, 2005 |       | 4,481,015              |       | $                                         | 1.94       |                                |       |   |
|                                 |       |                   |       |                                      |       |                                |       |
| Granted                              |       | 189,295                |       | $                                         | 1.77       |                                |       |   |
| Exercised                            |       | (29,795                | )          | $                                         | 1.34       |                                |       |   |
| Cancelled/forfeited                  |       | (32,867                | )          | $                                         | 3.26       |                                |       |   |
| Outstanding,  September 30, 2006     |       | 4,607,648              |       | $                                         | 1.93       |                                | $          | 1,874 |   |
| Exercisable, September  30, 2006     |       | 3,015,479              |       |                                      |       | $                                   | 1,354      |   |

 

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The following tablesummarizes information about stock options outstanding at September 30, 2006:
|                                             | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                  | ** ** | ** **                              | ** ** | **Weighted-**                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | ** **                              | ** ** | **Average**                             | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | ** **                              | ** ** | **Remaining**                           | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | ** **                              | ** ** | **Contractual**                         | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices** | ** ** | **Shares**                              | ** ** | **Life (Years)**                   | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| $0.24 - $0.39                               |       | 306,525                                 |       | 6.43                                    |       | $ | 0.37 |   | 227,398 |   | $ | 0.37 |   |
| $0.40 - $0.59                               |       | 1,288,142                               |       | 7.00                                    |       | 0.52 |   | 1,001,017 |   | 0.53 |   |
| $0.60 - $0.89                               |       | 10,000                                  |       | 7.04                                    |       | 0.62 |   | 5,000 |   | 0.62 |   |
| $0.90 - $1.34                               |       | 779,250                                 |       | 7.22                                    |       | 1.06 |   | 399,250 |   | 1.07 |   |
| $.1.35 - $2.01                              |       | 515,461                                 |       | 6.20                                    |       | 1.72 |   | 381,836 |   | 1.72 |   |
| $2.02 - $3.02                               |       | 1,093,498                               |       | 6.44                                    |       | 2.56 |   | 710,581 |   | 2.58 |   |
| $3.03 - $4.53                               |       | 427,137                                 |       | 7.68                                    |       | 4.23 |   | 142,062 |   | 4.27 |   |
| $4.54 - $6.80                               |       | 112,533                                 |       | 6.22                                    |       | 5.90 |   | 73,233 |   | 6.17 |   |
| $6.81 - $10.20                              |       | 40,000                                  |       | 4.38                                    |       | 8.25 |   | 40,000 |   | 8.25 |   |
| $10.21 - $15.30                             |       | 0                                       |       | 0                                       |       | 0 |   | 0 |   | 0 |   |
| $15.31 - $22.95                             |       | 31,046                                  |       | 3.35                                    |       | 20.44 |   | 31,046 |   | 20.44 |   |
| $22.96 - $34.43                             |       | 4,056                                   |       | 3.76                                    |       | 28.60 |   | 4,056 |   | 28.60 |   |
|                                        |       | 4,607,648                               |       | 6.77                                    |       | $ | 1.93 |   | 3,015,479 |   | $ | 1.88 |   |

 

8.                                       Accounting for Preferred Shares andDerivative Shares.

In June 2004, WorldGate completed a privateplacement of preferred stock. The preferred stock has a dividend rate of 5% perannum, payable quarterly, either by cash or through the issuance of commonstock at the Company’s option. The preferred stock has a staged maturity overthree years with scheduled payments of one third due after 18 months, one halfof the remainder due after 24 months and the balance due after 36 months, andmay be redeemed at maturity in cash or, at the Company’s option, subject tocertain conditions that may not be solely under the control of the Company,through the issuance of the number of shares of common stock determined bydividing the liquidation preference of the preferred shares by the then averagemarket price over the ten consecutive trading days prior to the date ofconversion.  If the effectiveness of the registration statement lapses,the Company ceases to be listed on certain specified exchanges and trading inthe Company’s stock is suspended or a change in control occurs with respect tothe Company, the Company may be required to settle redemption of the preferredstock with cash instead of its common shares.  Furthermore, since themarket price of the Company’s common stock cannot be predicted, the actualnumber of shares of the Company’s common stock that will be required if aredemption is made through the issuance of common stock also cannot bepredicted. The private placement includes numerous provisions intended toprotect these institutional investors including a cash payment penalty of 1.0%per month for unredeemed preferred shares once registration of the shares lapseand until the registration again becomes effective.

The preferred stock has embedded conversion options.Specifically, the holders of the preferred stock may convert their shares intothe Company’s common stock at a conversion price of $2.35 per share. Inaddition the Company may force conversion of the preferred stock into commonstock if the Company achieves certain price targets for its common stock andsatisfaction of certain other conditions, such as the existence of an effectiveregistration statement. In either event the conversion price is subject toadjustment if, at any time after the date the preferred shares were issued, theCompany issues or sells, or is deemed to have issued or sold, any shares of theCompany’s common stock for per share consideration less than the conversionprice of the preferred shares on the date of such issuance or sale. Accordingly, the number of common shares issuable upon the conversion of thepreferred shares cannot be predicted.  Furthermore, net-cash settlementmay be required in the event of conversion default under certain circumstancesthat may not be solely under the control of the Company.  If theeffectiveness of the registration statement lapses, the Company ceases to belisted on certain specified exchanges and trading in the Company’s stock issuspended or a change in control occurs with respect to the Company, theCompany may be required to settle a conversion of the preferred stock with cashinstead of its common shares.

Also, as part of the private placement the Companyissued five-year warrants to purchase up to 803,190 shares of our common stockat an exercise price of $2.69 per share and five-year warrants to purchase upto 803,190 shares of our common stock at an exercise price of $3.14 per share.The investors also received an additional investment right, for a limitedperiod of time, to purchase 1,606,383 additional shares of common stock sharesat $3.14 a share. This exercise price of the warrants is subject to adjustmentif, at any time after the date the warrants were issued, the Company issues orsells, or is deemed to have

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issued or sold, anyshares of the Company’s common stock for per share consideration less than theexercise price of the warrants on the date of such issuance or sale. Accordingly, the number of common shares that will be issued upon the exerciseof the warrants cannot be predicted.  As of September 30, 2006,125,000 warrants exercisable at $2.69 had been exercised and 51,915 warrantsexercisable at $3.14 had been exercised.  All of the additional investmentrights had been exercised as of June 30, 2006. Based on anti-dilutionprovisions contained within this private placement the $2.69 warrants weremodified effective August 11, 2006 to an exercise price of $2.59 and the numberof outstanding warrants were increased by 25,975 as a result of a dilutivetransaction on this date related to the issuance of convertible debentures andwarrants.  These warrants were further modifiedeffective October 13, 2006 to an exercise price of $2.52 and the number ofoutstanding warrants was further increased by 19,506 as a result of a dilutivetransaction on this date also related to the issuance of convertible debenturesand warrants.   Based on anti-dilutionprovisions contained within this private placement the $3.14 warrants were alsomodified effective August 11, 2006 to an exercise price of $3.01 and the numberof outstanding warrants were increased by 31,529 as a result of a dilutivetransaction on this date related to the issuance of convertible debentures andwarrants.  These warrants were furthermodified effective October 13, 2006 to an exercise price of $2.92 and thenumber of outstanding warrants was further increased by 24,192 as a result of adilutive transaction on this date also related to the issuance of convertibledebentures and warrants.

Of the 7,550 preferred shares issued under thisprivate placement, 7,384 shares have been redeemed as of September 30,2006.

With respect to the Company’s accounting for thepreferred stock, Emerging Issues Task Force (“EITF”) Topic D-98, paragraph 4,states that Rule 5-02.28 of Regulation S-X requires securities withredemption features that are not solely within the control of the issuer to berecorded outside of permanent equity. As described above, the terms of thepreferred stock include certain redemption features that may be triggered byevents that are not solely within the control of the Company, such as apotential failure in the Company’s ability to maintain an effectiveregistration statement. Furthermore, the actual number of shares of commonstock required to satisfy redemption is based upon the market value of thecommon stock at the time of the redemption, which cannot be predicted.Accordingly, the Company has classified the preferred stock as temporary equityand the value ascribed to the redeemable preferred stock upon initial issuance,i.e. at June 24, 2004, was the amount received in the transaction minusthe fair value ascribed to the conversion options and warrants. The initialvalue of the redeemable preferred stock is accreted up to the redemption value(the amount received in the transaction) over the future relevant periods usingthe interest method. The value of the redeemable preferred stock at September30, 2006 was $130.

The terms of the preferred stock include certainconversion options that represent derivative financial instruments underparagraph 12 of SFAS No. 133 and thus were separated from the preferredstock and valued using the Black-Scholes option pricing model.  Theconversion options include certain provisions that could result in a variablenumber of shares to be issued upon conversion, adjustment to the strike priceat which conversion shares will be determined, or the requirement for theCompany to settle the conversion options in cash.  EITF 00-19, “Accounting for DerivativeInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock,”states that if the conversion options require net cash settlement in the eventof circumstances that are not solely within the Company’s control they shouldbe classified as a liability measured at fair value on the balance sheet.

The terms of the five-year warrants include cashpenalty provisions in the event that the Company fails to meet its obligationsto deliver registered shares to the warrant holder upon exercise and ananti-dilution provision that could result in a variable number of shares to beissued upon warrant exercise. Additionally, the terms and conditions of thewarrants provide for net settlement through cashless exercise whereby theshares delivered to the warrant holder would be readily convertible to cash. Inaccordance with EITF 00-19 and given the terms and conditions of the warrantsas outlined above, the Company has classified the warrants as a liability onits balance sheet measured at fair value using the Black-Scholes option pricingmodel.

The Company accounts for both the conversion optionsand warrants using the fair value method at the end of each quarter, with theresultant gain or loss recognition recorded against earnings. Both the warrantsand conversion options are valued using the Black-Scholes valuation model.Actual period close common stock price ($1.47), applicable volatility rate(104%), and the period close risk-free interest rates (4.72% and 4.55%) for theinstrument’s contractual remaining life (.75 and 2.75 years) (continuouslycompounded), are the key assumptions used in the valuation calculation.  The result was a $279 and $59, respectively,non cash gain and charge, respectively, for the three and nine months endedSeptember 30, 2006, and a non cash gain of $1,165 (restated) and $7,974(restated), respectively, for the three and nine months ended September 30,2005.

At September 30, 2006, after the mark to marketadjustments, the balances of the conversion features derivative liability andthe warrants derivative liability were $23 and $1,094, respectively.

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9.                                       Accountingfor Secured Convertible Debentures.

On August 11, 2006 the Company completed a privateplacement with an institutional investor of a convertible debenture in theaggregate principal amount of up to $11,000. This convertible debenture has a maturity of three years, an interestrate of 6% per annum, and is convertible at the option of the investors intoWorldGate common stock at a conversion price equal to the lesser of $1.75 pershare or 90% of the average of the five lowest daily volume weighted averageclosing price (“VWAP”) of the common stock during the fifteen trading daysimmediately preceding the conversion date (subject to adjustment in the eventof stock dividends and splits and certain distributions to stockholders,fundamental transactions, and future dilutive equity transactions). Interest is payable at maturity, and the Company may elect to pay theinterest amount in cash or shares of our common stock. There was $50 of accruedinterest as of September 30, 2006. Through September 30, 2006 the investors converted $200 of the convertibledebt into 142,814 shares of the Company’s common stock. In October 2006, theinvestors converted an additional $250 of the convertible debt into 199,412shares of the Company’s common stock.  OnNovember 7, 2006 the investors converted an additional $200 of the convertibledebt into 184,553 shares of the Company’s common stock.

The Company received $6,000 upon the closing of thetransaction ($5,615, net of transaction costs) and the remaining $5,000($4,700, net of transaction costs) was received on October 13, 2006 afterreceiving stockholder approval on October 11, 2006 and obtaining an effectiveregistration of the shares of common stock issued and issuable upon conversionof the convertible debentures in the first tranche of this transaction.

The Company has the right to redeem all or any portionof the principal amount of the convertible debentures in cash at any time uponnot less than four business days notice if the closing price of our stock isless than $1.75 per share.  Such early redemption will, however, requireus to pay a 10% prepayment premium.   In addition, without anyprepayment premium, the Company has the right to force the holders to convert amaximum of $500 of the principal amount of the convertible debenture in anythirty day period if for five consecutive trading days the VWAP of our commonstock is above $1.925 per share but less then $3.50 per share and providing thedaily trading volume exceeds 200,000 shares for these five days, and certainother conditions are met.  If the VWAP ofour common stock is greater than $3.50 per share for 30 consecutive tradingdays, the daily trading volume exceeds 250,000 shares for five days prior, andif certain other conditions are met, the Company can also force the holder toconvert all or any portion of the outstanding principal and interest intoshares of our common stock without any prepayment premium.

There are some restrictions on the holder’s right toconvert the convertible debentures.  The holder cannot make anyconversions below $1.75 per share (i) until the earlier of the date registeredcommon stock can be issued pursuant to such conversion or January 1, 2007, (ii)which would exceed $500 in principal amount in any calendar month, or (iii)which would result in the issuance of more than 840,000 shares of our commonstock per calendar month (provided that this maximum share limit will be waivedby the Company unless it elects to pay the holder in cash the difference invalue between 840,000 shares and the number of shares the holders wishes toconvert, up to the $500 per month conversion limit).  If the Company is indefault under the convertible debenture these limitations are waived. Theholder is also not restricted in making conversions at $1.75.  In no case, however may the holder convertthe convertible debentures if (x) it would result in beneficial ownership ofmore than 9.99% of our outstanding common stock (though this provision can bewaived by the holder upon 65 days prior notice), or (y) such conversion would,without stockholder approval, cause the Company to issue more than 19.99% ofits outstanding shares as determined immediately prior to consummation of thetransaction.  Under certain circumstances, the convertible debentureholders are entitled to have the conversion price adjusted to correspond tocommon stock holders’ rights to any stock dividend, stock split, stockcombination or reclassification of shares. The $1.75 conversion price is alsosubject to a weighted average dilution adjustment if the Company issues shares(apart from certain excluded issuances) of our capital stock at an effectiveprice of less than $1.75 per share.  The Company also granted theconvertible debentures holders a security interest in all of our assets.  Moreover, the Company is required to registerthe shares of common stock issuable to the investor for resale to the publicpursuant to a registration rights agreement, containing customary terms,conditions and indemnities.  The privateplacement includes numerous provisions intended to protect the institutionalinvestors including a cash payment penalty of 1.0% per month for the periodabove 120 days from the effective date of the agreement that the shares in thetransaction fail to be registered with the aggregate penalty capped at 12%.

In addition, the aggregate number of shares to beissued upon conversion, exercise of the warrants, payment for commitmentshares, and payment of liquidated damages pursuant to the registration rightsagreement has been limited to 61,111,111 shares of common stock.

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As part of this private placement the Company issuedfive-year warrants to purchase a total of up to 2,595,000 shares of WorldGatecommon stock, with 1,145,000 of the warrants having an exercise price of $1.85per share (with 624,545 of these warrants issued at the initial closing and 520,455warrants issued at the closing of the second tranche of funding), 1,100,000 ofthe shares having an exercise price of $2.35 per share (with 600,000 of thesewarrants issued at the initial closing and 500,000 warrants issued at theclosing of the second tranche of funding), and 350,000 warrants having anexercise price of $2.60 per share (with 190,909 of these warrants issued at theinitial closing and 159,091 warrants issued at the closing of the secondtranche of funding).  In connection withthe private placement, the Company has issued to the investor as a commitmentfee 177,419 shares of common stock with a fair value at issuance ofapproximately $222.

Upon any liquidation, dissolution or winding up of ourCompany, the holder of the convertible debenture will be entitled to receivethe principal amount of the convertible debenture, together with accrued andunpaid interest, prior to any payment to the holders of our common andpreferred stock.

The terms of the warrant agreements provide for theadjustment of the exercise price and the number of shares of common stock to beissued upon the Company’s issuance of certain securities deemed to be dilutiveunder the agreement.    Under certainconditions, the holder may exercise these warrants on a cashless basis.

The market price of the Company’s common stock cannotbe predicted.   Furthermore, subject tothe share limitation, as discussed above, the actual number of shares of theCompany’s common stock that will be required if a conversion of the convertibledebenture is made through the issuance of common stock also cannot bepredicted.  Should the Company’srequirements to issue shares under these convertible debenture agreementsexceed the share limitation, or if it is not listed or quoted for trading on atleast the NASDAQ OTC Bulletin Board, the Company may be required to settle theconversion of the convertible debentures with cash instead of its common stock.

Accounting for theprivate placement.

The Company accounts for conversion options embeddedin convertible notes in accordance with Statement of Financial AccountingStandard (“SFAS) No. 133 “Accounting for Derivative Instruments andHedging Activities” (“SFAS 133”) and EITF 00-19 “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock” (“EITF 00-19”)  SFAS 133generally requires companies to bifurcate conversion options embedded inconvertible notes from their host instruments and to account for them as freestanding derivative financial instruments in accordance with EITF 00-19.   EITF 00-19 states that if the conversionoption requires net cash settlement in the event of circumstances that are notsolely within the Company’s control that they should be classified as aliability measured at fair value on the balance sheet.

Upon the issuance date and at September 30, 2006,there was an insufficient number of authorized shares of Common Stock in orderto permit exercise of all of the warrants issued on August 11, 2006.   In accordance with EITF 00-19, when thereare insufficient authorized shares, the obligation for the exercise of investorwarrants should be classified as liability measured at fair value on thebalance sheet.   Accordingly, at August11, 2006, the convertible feature of the convertible debenture and the warrantswere recorded as derivative liabilities of $4,446 and $1,269,respectively.  On October 11, 2006 theCompany received shareholder approval to increase the authorized shares from 80,000,000to 120,000,000.  Effective with thisincrease the value of the warrants will be reclassified to equity in accordancewith the provisions of EITF 00-19.

The Company accounts for both the conversion optionsand warrants using the fair value method at the end of each quarter, with theresultant gain or loss recognition recorded against earnings. Both the warrantsand conversion options are valued using the Black-Scholes valuation model,applying actual period close common stock price ($1.47), applicable volatilityrate (104%), and the period close risk-free interest rates (4.91% and 4.71%)for the instrument’s remaining contractual life (2.87 and 4.87 years).

The sum of the fair values of the convertible featureand the warrants, $5,714 in the aggregate, exceeded the net proceeds of $5,615.   The difference of $99 was charged to theprovision for fair value adjustment, upon issuance.    Accordingly, the Company recorded adiscount equal to the face value of the convertible debenture, which will beamortized using the effective interest rate method over the three yearterm.  The common stock issued as fees inthe transaction was recorded at a net value of $0, as there was no residualvalue remaining.

During the three and nine months ended September 30,2006, $200 in face value of the convertible debentures were converted,resulting in the issuance of 142,814 share of common stock.  As a result of the conversion, $200 of thediscount on the convertible debenture has been charged to discount amortization.

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For the three and nine months ended September 30,2006, the company has recorded total discount amortization of $201 andmark-to-market adjustments of the conversion feature derivative liability andthe warrants derivative liability resulted in a gain of $90 and a loss of $253,respectively.

At September 30, 2006, the balances of the convertibledebentures and the offsetting related discount were $5,800 and $5,799respectively.

At September 30, 2006, after the mark to marketadjustments, the balances of the conversion features derivative liability andthe warrants derivative liability were $4,206 and $1,522, respectively.

Liquidated Damages.

The Company accounts for potential registration rightsliquidated damage obligations in accordance with EITF Issue No. 05-4, “TheEffect of a Liquidated Damages Clause on a Freestanding Financial InstrumentSubject to EITF Issue No. 00-19, ‘Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock.’”    The Company has adopted View C of thispronouncement and treats registration right agreements as a free standingderivative.  Any liability for liquidateddamages under the agreement is deemed to be de-minimus.

10.                                 Warranty Reserve.

The Company provides a warranty covering defectsarising from the sales of its video phone product. This warranty is limited toa specific time period. As of September 30, 2006, the Company has a reserve of$83 that is based on a percentage of product sales.  As of September 30, 2006, the Companyhas not incurred any material warranty costs related to our product. Warrantycosts are charged to cost of revenues when they are probable and reasonablyestimable. While the Company believes its estimate at September 30, 2006is reasonable and adequate, it is subject to change based on our future salesand experience, which may require an increase or decrease in our reserve.

During the three and nine months ended September 30,2006, the Company reduced its warranty reserve of $336 at December 31, 2005 by$6 and $253, respectively.  This adjustment,recorded as an increase to the gain recorded from the termination on February17, 2006 of the Company’s agreement with General Instrument, is a result of theelimination of the warranty exposure for products previously sold and thenrepurchased from General Instrument under this termination.

11.                                 Commitmentsand Contingencies.

*Leases*

The Company’s current lease was signed on September 1,2005 and covers 42,500 square feet at an annual rate of $11.40 per square footwith a 3% increase annually, cancelable by either party with eight monthsnotice, with a termination by tenant also including six months terminationfee.  Total rent expense for the threemonths ended September 30, 2006 and 2005 amounted to approximately $160 and$118, respectively.  Total rent expensefor the nine months ended September 30, 2006 and 2005 amounted to approximately$478 and $271, respectively.

In November 2003, the Company entered into a 60month lease for office equipment. As of September 30, 2006, there remainsa total of $12 to be paid over the remaining period of this lease.  In October 2005, the Company enteredinto a 36 month lease for office equipment. As of September 30, 2006 thereremains a total of $15 to be paid over the remaining period of this lease.

The future minimum commitments under non-cancelableleases for the balance of each of the fiscal years ending December 31 are asfollows:
|                                                   | ** ** | **(Dollars in  Thousands)** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| 2006 (October 1,  2006 through December 31, 2006) |       | $                                | 128        |   |
| 2007                                              |       | 517                              |       |
| 2008                                              |       | 530                              |       |
| 2009                                              |       | 535                              |       |
| 2010                                              |       | 363                              |       |
| Total                                             |       | $                                | 2,073      |   |

 

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*Significant Agreements and Transactions*

On April 28, 2004, the Company entered into asix-year distribution agreement with General Instrument for the marketing anddistribution of the Ojo video phone. This agreement provided for GeneralInstrument to be WorldGate’s exclusive distributor of its broadband video phoneproducts and for WorldGate to be General Instrument’s exclusive supplier of itsbroadband video phone products. After a period of eighteen months following thecommercial availability of the Ojo video phone, this mutual exclusivity wouldterminate unless General Instrument elected to continue the mutual exclusivityafter having achieved certain minimum sales targets for the Ojo video phone.General Instrument could have, however, at its option, elected to terminatethis mutual exclusivity at any time. In the event mutual exclusivity terminatesor is terminated, then for a twelve month period thereafter, WorldGate was tocontinue to be General Instrument’s exclusive supplier of broadband videophones, but would be free to sell video phone products to customers other thancertain defined General Instrument accounts. During this twelve month period,General Instrument had a right of first refusal to accept and fill any ordersfor video phone products that WorldGate obtained from non-General Instrumentaccounts, and was obligated to use good faith efforts to solicit and acceptproduct orders from General Instrument accounts in a commercially reasonable manner.During any period of exclusivity under this agreement the Company was reliantupon General Instrument and its distribution partners, including, for example,wholesalers, retailers and service providers, to provide the worldwide salesand distribution of the Ojo video phone. Although the agreement requiredGeneral Instrument to provide for certain marketing and promotional activitiesfor the Ojo video phone, there were no required sales quotas for the agreementto remain in effect, and General Instrument controlled the volume of productsbeing distributed by our Company. Neither party was permitted to terminate theagreement except in cases of uncured breaches of the agreement or as a resultof insolvency events suffered by the other party. If General Instrument and itspartners were not successful, or if their activities did not lead tosignificant sales of our product, our operating results could have beenadversely affected, our revenue could be significantly reduced and the Companycould lose potential customers.  Inconnection with the Development and Distribution Agreement with GeneralInstrument, the Company issued warrants to General Instrument to purchase600,000 shares of our common stock, 300,000 at an exercise price of $1.4375 pershare with the execution of the agreement in April 2004, and 300,000 at anexercise price of $1.75 upon the delivery to General Instrument of acceptableprototypes for the product. Additionally, the Company agreed to issue warrantsto purchase up to an additional 1,650,000 shares of our common stock, upon theachievement of certain sales milestones, at an exercise price based upon theaverage closing sales price of our common stock during the 20 day periodpreceding the issuance of each warrant.

On February 17, 2006, the Company mutually agreed withGeneral Instrument to end their mutually exclusive distribution agreement.  The ending of this agreement immediatelyterminated this exclusivity for both parties, and accordingly enabled WorldGateto expand its focus in bringing Ojo to the marketplace. In addition to itscurrent role for development and manufacture of Ojo, WorldGate became directlyresponsible for the advertising, marketing, and distribution of its products.

Based upon our actual experience to date, the Companydoes not believe it is necessary to establish a reserve for retailer returns toGeneral Instrument.  In the Company’sdiscussions with the retailers eligible for such returns, the retailers haveindicated their intention to continue to sell the Company’s video phoneproducts and, to date the Company has received minimal returned products.

As part of ending the development and distributionagreement, General Instrument has agreed to certain restrictions on itsdevelopment of a stand-alone video phone product which has as a primaryfunction the making or receipt of video phone calls over a broadbandnetwork.  Such restrictions will end in January 2007.

Net revenues recognized from General Instrument, aninvestor, were approximately $0 and $2,265, respectively, for the three monthsended September 30, 2006 and 2005 respectively.  Net revenues from continuing operationsrecognized from General Instrument, an investor, were approximately $0 and$3,841, respectively, for the nine months ended September 30, 2006 and2005 respectively. This investor accounted for approximately 100% of therevenues for the three and nine months ended September 30, 2005.  Accounts receivable from this investor was $0and $123 as of September 30, 2006 and December 31, 2005, respectively. InApril and September 2004, the Company issued warrants to thisinvestor to purchase shares of our common stock, with the April warrantshaving an exercise price of $1.4375 per share and the September warrantshaving an exercise price of $1.75 per share. Included in General andAdministrative expenses in September 2004 were $606 of expenses relatingto the valuation of these warrants. This valuation was determined by using theBlack-Scholes fair value option model. The following assumptions were used: expectedvolatility of 65%; average risk-free interest rate of 3.43%; dividend yield of0%; and an expected life of 5.0 years.

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The Company has a current multi-year agreement withMototech , an investor, to provide the Company with engineering and developmentsupport. As a result of this agreement, the Company has expensed approximately$75 and $97, respectively for the three months ended September 30, 2006 and2005. For the nine months ended September 30, 2006 and 2005, the Companyexpensed approximately $275 and $255, respectively. Accounts payable to thisinvestor amounted to $408 and $1,173 at September 30, 2006 and December31, 2005, respectively. This agreement provides for contracted services,including hardware and software development, and the creation and developmentof tools to facilitate the Company’s engineering efforts. This agreement doesnot provide for ongoing royalties, purchase provisions, or for any requirementto provide additional funding to the Company. Net revenues from operations recognized from Mototech were approximately$10 and $0 for the three months ended September 30, 2006 and 2005,respectively.  Net revenues fromoperations recognized from Mototech were approximately $405 and $0 for the ninemonths ended September 30, 2006 and 2005, respectively.  This investor accounted for approximately 1%and 0% of the revenues for the three months ended September 30, 2006 and2005, respectively, and 24% and 0% of the revenues for the nine months endedSeptember 30, 2006 and 2005, respectively. Accounts receivable from this investor were $1 and $0, respectively, asof September 30, 2006 and December 31, 2005.

In June 2004, WorldGate completed a private placementof 7,550 shares of preferred stock at a stated value of $1,000 per share. Thepreferred stock has attached warrants and conversion options. Specifically, theholders of the preferred stock may convert their shares into our common stockat a conversion price of $2.35 per share. The private placement includesnumerous provisions intended to protect these institutional investors includinga cash payment penalty of 1.0% per month for unredeemed preferred shares onceregistration of the shares lapse and until the registration again becomeseffective. A registration statement for these securities was originally filedcontaining fiscal 2003 financial statements, and an amendment to thisregistration statement which included fiscal 2005 financial statements was notregistered until June 1, 2006.  Untilsuch time as the shares become registered the Company was subject to thepenalty provision under this private placement.

In August 2005, the Company completed a private placementfor $17,500 of its common stock and warrants with several institutionalinvestors. The Company issued 4,666,664 shares of its common stock at $3.75 pershare to the participating investors. The Company also issued five-yearwarrants to purchase a total of 1,671,947 shares of its common stock: 1,633,333shares to the investors at an exercise price of $5.00 per share, and 38,614shares to the placement agent at an exercise price of $4.53 per share. The investors also received an additional investment right, for a limitedperiod of time, to purchase 1,554,000 additional shares of common stock at$4.12 per share.  The private placementincludes numerous provisions intended to protect these institutional investorsincluding a cash payment penalty of 1.5% per month for the period above120 days from the effective date of the agreement that the shares inthe transaction fail to be registered. The Registration Statement covering theshares under this private placement was not declared effective until June 1,2006.  Until such time as the shares wereregistered the Company was subject to the penalty provision under this privateplacement.   For the nine months endedSeptember 30, 2006 and 2005 the Company recorded and expensed related penaltiesof $1,387 and $0, respectively. The related unpaid penalties accrued as ofSeptember 30, 2006 and December 31, 2005 was $472 and $525, respectively.  On July 25, 2006, the Company amended theterms of the additional investment right that was granted to an investor as partof the August 2005 private placement, with respect to a portion of shares ofcommon stock purchasable thereunder and agreed to apply $158 of accruedpenalties towards the exercise price of such amended additional investmentright, for the purchase of 129,950 shares of common stock. The penalties hadaccrued with respect to the Company’s inability to register the shares acquiredby such investor in the private placement within 120 days of thetransaction.  In consideration for thisamendment and application of the exercise proceeds the investor agreed toforego any cash payment of the penalties other than as available through theproceeds of the exercise of the amended investment right and to grant to theCompany a release of all claims relating to the late registration of theprivate placement shares, other then the aforesaid penalties.  The amendedadditional investment right provides that the investor thereof may purchase the129,950 shares of common stock for a period of 760 days beginning June 1, 2006 foran exercise price of $1.515 per share.  The terms of the additionalinvestment rights with respect to the remaining 1,424,050 shares of commonstock purchasable thereunder remain unchanged. On July 26, 2006 this investor exercised the additional investment rightfor 129,950 shares. On July 31, 2006 the amended additional investmentright with respect to the remaining 1,424,050 shares of common stock expired.

Registration statements for the securities soldpursuant to the June 2004, December 2004 and August 2005 private placementswere originally filed containing financial statements that were current at thetime of the filing. Subsequently, the Company initiated a process to amend,restate, and re-file certain of its 2003, 2004 and 2005 financial statements tocorrect an error in the accounting treatment for various security components ofour private placements. As a result the registration statements then on filealso needed to be amended to reflect these changes in our financial statements.Amended registration statements were subsequently filed with the SEC to reflectthe amended and restated financial statements, and became effective on June 1,2006.

On August 11, 2006the Company completed a private placement with an institutional investor of aconvertible

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debenture in theaggregate principal amount of up to $11,000. This convertible debenture has a maturity of three years, an interestrate of 6% per annum, and is convertible at the option of the investors intoWorldGate common stock at a conversion price equal to the lesser of $1.75 pershare or 90% of the average of the five lowest daily volume weighted averageclosing price (“VWAP”) of the common stock during the fifteen trading daysimmediately preceding the conversion date (subject to adjustment in the eventof stock dividends and splits and certain distributions to stockholders,fundamental transactions, and future dilutive equity transactions). Interest is payable at maturity, and the Company may elect to pay theinterest amount in cash or shares of our common stock. Through September 30,2006 the investors converted $200 of the convertible debt into 142,814 sharesof the Company’s common stock. In October 2006, the investors converted anadditional $250 of the convertible debt into 199,412 shares of the Company’scommon stock.   On November 7, 2006 theinvestors converted an additional $200 of the convertible debt into 184,553shares of the Company’s common stock.

The Company received $6,000 upon the closing of thetransaction ($5,615, net of transaction costs) and the remaining $5,000($4,700, net of transaction costs) was received on October 13, 2006 afterreceiving stockholder approval on October 11, 2006 and obtaining an effectiveregistration of the shares of common stock issued and issuable upon conversionof the convertible debentures in the first tranche of this transaction.

The Company has the right to redeem all or any portionof the principal amount of the convertible debentures in cash at any time uponnot less than four business days notice if the closing price of our stock isless than $1.75 per share.  Such early redemption will, however, requireus to pay a 10% prepayment premium.   In addition, without anyprepayment premium, the Company has the right to force the holders to convert amaximum of $500 of the principal amount of the convertible debenture in anythirty day period if for five consecutive trading days the VWAP of our commonstock is above $1.925 per share but less then $3.50 per share and providing thedaily trading volume exceeds 200,000 shares for these five days, and certainother conditions are met.  If the VWAP ofour common stock is greater than $3.50 per share for 30 consecutive tradingdays, the daily trading volume exceeds 250,000 shares for five days prior, andif certain other conditions are met, the Company can also force the holder toconvert all or any portion of the outstanding principal and interest intoshares of our common stock without any prepayment premium.

There are some restrictions on the holder’s right toconvert the convertible debentures.  The holder cannot make anyconversions below $1.75 per share (i) until the earlier of the date registeredcommon stock can be issued pursuant to such conversion or January 1, 2007, (ii)which would exceed $500 in principal amount in any calendar month, or (iii)which would result in the issuance of more than 840,000 shares of our commonstock per calendar month (provided that this maximum share limit will be waivedby the Company unless it elects to pay the holder in cash the difference invalue between 840,000 shares and the number of shares the holders wishes toconvert, up to the $500 per month conversion limit).  If the Company is indefault under the convertible debenture these limitations are waived. The holderis also not restricted in making conversions at $1.75.  In no case, however may the holder convertthe convertible debentures if (x) it would result in beneficial ownership ofmore than 9.99% of our outstanding common stock (though this provision can bewaived by the holder upon 65 days prior notice), or (y) such conversion would,without stockholder approval, cause the Company to issue more than 19.99% ofits outstanding shares as determined immediately prior to consummation of thetransaction.  Under certain circumstances, the convertible debentureholders are entitled to have the conversion price adjusted to correspond tocommon stock holders’ rights to any stock dividend, stock split, stockcombination or reclassification of shares. The $1.75 conversion price is alsosubject to a weighted average dilution adjustment if the Company issues shares(apart from certain excluded issuances) of our capital stock at an effectiveprice of less than $1.75 per share.  The Company also granted the convertibledebentures holders a security interest in all of our assets.  Moreover, the Company is required to registerthe shares of common stock issuable to the investor for resale to the publicpursuant to a registration rights agreement, containing customary terms, conditionsand indemnities.  The private placementincludes numerous provisions intended to protect the institutional investorsincluding a cash payment penalty of 1.0% per month for the period above 120days from the effective date of the agreement that the shares in thetransaction fail to be registered with the aggregate penalty capped at 12%.

In addition, the aggregate number of shares to beissued upon conversion, exercise of the warrants, payment for commitmentshares, and payment of liquidated damages pursuant to the registration rightsagreement has been limited to 61,111,111 shares of common stock.

As part of this private placement the Companyissued  five-year warrants to purchase atotal of up to 2,595,000 shares of WorldGate common stock, with 1,145,000 ofthe warrants having an exercise price of $1.85 per share (with 624,545 of thesewarrants issued at the initial closing and 520,455 warrants issued at theclosing of the second tranche of funding), 1,100,000 of the shares having anexercise price of $2.35 per share (with 600,000 of these warrants issued at theinitial closing and 500,000 warrants issued at the closing of the secondtranche of funding), and 350,000 warrants having an exercise price of $2.60 pershare (with 190,909 of these warrants issued at the initial closing and 159,091warrants issued at the closing of the second tranche of funding).

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12.                                 NetLoss per Share.

Basic and diluted net income (loss) per common shareis computed by dividing the net income (loss) available to common stockholdersfor the period by the weighted average number of shares of common stockoutstanding during the period.  Thecalculation of diluted net income (loss) per common share excludes potentialcommon shares if the effect is antidilutive. Potential common shares comprise shares of common stock issuable uponthe exercise of stock options and warrants. The number of potential common shares which would have been assumed tobe converted in the three and nine months ended September 30, 2006 and have adilutive effect if the Company had income from continuing operations, or if theoptions’ exercise price was less than the average market price of the commonshares, is 15,187,535 and 15,187,535, respectively, and for the three and ninemonths ended September 30, 2005, the number of shares are 4,576,923 and4,498,634, respectively.

13.                                 Stock Options and Warrants.

In October 2004, the Company’s stockholdersapproved the 2003 Equity Incentive Plan (“2003 Plan”). This plan is intended toreplace the 1996 Plan for new grants. No additional shares were reserved forthe new plan but rather all available shares under the 1996 Plan were madeavailable for the new plan. As with the 1996 Plan, the 2003 Plan includes thesame automatic annual increase in the number of shares reserved for use withthe plan equal to the greater of 4% of the then outstanding shares of theCompany’s common stock or 1,000,000 shares. In addition to ISOs and NQSOs, thenew plan also provides for performance based awards and restricted stock.  At September 30, 2006, there were 8,085,730shares reserved under these plans, and 4,607,648 options outstanding.  During the three and nine months endedSeptember 30, 2006, there were 55,500 and 189,295, respectively, optionsgranted to employees and a consultant. During the three and nine months ended September 30, 2006, there were 0and 29,795 options exercised.

At September 30, 2006 there were warrants outstandingexercisable into 6,217,721 shares of the Company’s common stock (for moredetails, refer to Note 3).

14.                                 Revenue Recognition.

Revenue is recognized when persuasive evidence of anarrangement exists, the price is fixed or determinable, the collectibility isreasonably assured, and the delivery and acceptance of the equipment hasoccurred or services have been rendered.  Management exercises judgment inevaluating these factors in light of the terms and conditions of its customercontracts and other existing facts and circumstances to determine appropriaterevenue recognition. Due to our limited commercial sales history, our abilityto evaluate the collectibility of customer accounts requires significantjudgment. The Company evaluates its equipment customer and service customers’accounts for collectibility at the date of sale and on an ongoing basis.

For the year ended December 31, 2005, and through midFebruary 2006, the Company had only one customer for the purchase of itsproduct and the agreement with this customer included several elements relevantto revenue recognition including: (a) the customer had no general right toreturn the product;  (b) the customer earned warrants upon thepurchase of significant video telephony units and the value of these warrantswould result in a reduction of recognized revenue (the value of these warrants hasbeen routinely monitored by the Company and is currently deemed to beinsignificant, however, should the value of these warrants become material anoffset would be made against revenues); (c) penalties are payable to thecustomer if certain excessive field failure rates are exceeded; (d) the Company and the customer share in the benefit achieved by productcost reductions; (e) penalties are payable to the customer if the Companyfails to deliver shipments on a timely basis; (f) the Company extends tothe customer a limited product warranty for a term not to exceed three years(the Company maintains a warranty reserve based upon the percentage of productsales consistent with industry comparable failure rates and the warranty periodprovided by the agreement).  Beginning inmid February 2006, as a result of the termination of the General Instrumentmarketing and distribution agreement, the Company began selling its products tomultiple customers and now evaluates its revenue recognition policy on acustomer by customer basis.

Revenues are also offset by a reserve for any pricerefunds and consumer rebates consistent with the EITF Issue 01-9, “Accountingfor Consideration Given by a Vendor to a Customer.”

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As an incentive to promote delivery of the units, aspecial product launch discount was provided by the Company to a distributor asa quantity restricted reduction to the unit contract based price in effect. Forthe year ended December 31, 2005, this discount was $398.  In addition, the Company offered a forwardpricing program to its former distributor and a rebate program to consumers, asfurther incentives for the 2005 holiday season. These incentive programs beganin the fourth quarter of 2005 and terminated during the first quarter of 2006.Consistent with the EITF Issue 01-9, the Company has offset its revenues forthe year ended December 31, 2005 by $212 for a reserve for the totalestimated liability for the forward pricing program, and $91 as an estimatedliability associated with the rebate program.  The total of the productlaunch discount, refunds and rebates for the year ended December 31, 2005was $701.  There were no product launchdiscounts, refunds or rebates for the three and nine months ended September 30,2005.   The forward pricing program was terminatedwith the termination on February 17, 2006 of the distribution agreement withGeneral Instruments, and this liability was reversed and recorded as a $212increase to the gain realized from termination of this agreement.  On March 13, 2006, the Company announced thatit was going to offer a new consumer rebate program effective April 1, 2006 andterminating June 30, 2006.  At September30, 2006, there was an estimated liability of $57 associated with this rebateprogram.  Also, on March 13, 2006 theCompany announced a price protection program for certain retailers holding Ojovideo phone inventory as of April 1, 2006. At September 30, 2006, there was an estimated liability of $2 associatedwith this price protection program. These rebate and price protection programs were recorded as offsetsagainst revenues in the three and nine months ended September 30, 2006.

As part of ending its agreement with GeneralInstrument, and in anticipation of WorldGate inventory requirements as a resultof taking full responsibility for product distribution, WorldGate negotiatedthe right to buy back about two-thirds of the units sold to General Instrument,valued at approximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost the Company to purchase the same inventory from its manufacturingsources.  As a result the Companyrecorded a reserve for returns and reduced revenue in the amount ofapproximately $2,310, during the fourth quarter of 2005. In addition, theCompany has recorded no revenue for units shipped to General Instrument in thefirst quarter 2006 and has recorded a gain on termination of this agreement ofapproximately $1,777 during the nine months ended September 30, 2006 as aresult of the lower purchase price of the inventory repurchased from GeneralInstrument ($1,327, net of the cost of rework for rebranding the product andthe adjustment of the inventory to its current replacement value) and reversalof the product refund program reserve ($212) as well as an adjustment of thewarranty reserve for products repurchased ($233), both of which resulted fromtermination of the Company’s agreement with General Instrument.

15.                                 Risks and uncertainties.

Our primary line of business is the development ofvideo phone products and technology. The Company is still in the process oflaunching our first product based on this technology and, although the Companyhas realized some revenues for the commercial sale of our product, the revenuesto date have not been substantial. Given the early stage of our product and thelack of operating history in the video phone business, it is difficult topredict our future results.

On April 28, 2004, the Company entered into amulti-year agreement with General Instrument for the worldwide development anddistribution of the Ojo personal video phone. This agreement provided forGeneral Instrument to be WorldGate’s exclusive distributor of its broadbandvideo phone products and for WorldGate to be General Instrument’s exclusivesupplier of its broadband video phone products. On February 17, 2006, the Company mutually agreed with GeneralInstrument to end this agreement.  Theending of this agreement immediately terminated this exclusivity for bothparties, and accordingly enabled WorldGate to expand its focus in bringing Ojoto the marketplace. In addition to its current role for development andmanufacture of Ojo, WorldGate became directly responsible for the advertising,marketing, and distribution of its products. Subsequent to the ending of theagreement with General Instrument the Company will depend upon distributionpartners, including, for example, wholesalers, retailers and service providers,to provide the worldwide sales and distribution of the Ojo video phone. If ourpartners are not successful, or if their activities do not lead to significantsales of our product, our operating results will be adversely affected, ourrevenue could be significantly reduced and the Company could lose potentialcustomers.

The Company also depends on relationships with thirdparties such as contract manufacturing companies, chip design companies andothers who may be sole source providers of key components and services criticalfor the product the Company is developing in our video phone business. A formalrelationship with Mototech has been established for the volume manufacture ofOjo. Our agreement with Mototech allows either party to terminate the agreementwith 90 days prior notice. If Mototech or other providers of components and/ormanufacturing services do not produce these components or provide theirservices on a timely basis, if the components or services do not meet ourspecifications and quality control standards, or if the components or servicesare otherwise flawed, the Company may have to delay product delivery, or recallor replace

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unacceptable products. Inaddition, such failures could damage our reputation and could adversely affectour operating results. As a result, the Company could lose potential customersand any revenues that it may have at that time may decline dramatically.

16.                                 SubsequentEvent.

Convertible Debentures

On October 13, 2006, the Company completed the secondtranche of the August 11,2006  privateplacement with an investor of Convertible Debentures in the principal amount of$5,000,000 upon which the Company received $4,700,000 net of transaction costs(for more details , refer to notes 3and 9).  This convertible debenturehas a maturity of three years, an interest rate of 6% per annum, and isconvertible at the option of the investor into our common stock at a conversionprice equal to the lesser of $1.75 per share or 90% of the average of the fivelowest daily volume weighted average closing price (“VWAP”) of the common stockduring the fifteen trading days immediately preceding the conversion date(subject to adjustment in the event of stock dividends and splits and certaindistributions to stockholders, fundamental transactions, and future dilutiveequity transactions).  Interest is payable at maturity, and the Companymay elect to pay the interest amount in cash or shares of our common stock.

As part of this second tranche of the privateplacement the Company issued five-year warrants to purchase a total of up to1,179,546 shares of WorldGate common stock, with 520,455 of the warrants havingan exercise price of $1.85 per share, 500,000 of the shares having an exerciseprice of $2.35 per share, and 159,091 warrants having an exercise price of$2.60 per share.

On October 11, 2006 the Company received shareholderapproval to increase the authorized shares from 80,000,000 to 120,000,000.

On October 12, October 20 and November 7,2006,convertible debentures with a face amount of $150,000, $100,000 and $200,000were converted by the holder, resulting in the issuance of 115,750, 83,292 and184,553 shares of common stock, respectively.

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# ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS.

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

The Company may from time to time make written or oralforward-looking statements, including those contained in the followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations.  The words “estimate,” “project,”“believe,” “intend,” “expect,” and similarexpressions are intended to identify forward-looking statements, although notall forward-looking statements contain these identifying words.  In order to take advantage of the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, weare hereby identifying certain important factors that could cause our actual results,performance or achievement to differ materially from those that may becontained in or implied by any forward-looking statement made by or on ourbehalf.  The factors, individually or inthe aggregate, that could cause such forward-looking statements not to berealized include, without limitation, the following: (1) difficulty indeveloping and implementing marketing and business plans, (2) industrycompetition factors and other uncertainty that a market for our products willdevelop, (3) challenges associated with distribution channels, including boththe retail distribution channel and HSD operators (e.g., uncertainty that theywill offer our products, inability to predict the manner in which they willmarket and price our products and existence of potential conflicts of interestsand contractual limitations impeding their ability to offer our products), (4)continued losses, (5) difficulty or inability to raise additional financing onterms acceptable to us, (6) departure of one or more key persons, (7) delistingof our common stock from the NASDAQ Capital Market, (8) changes in regulatoryrequirements, and (9) other risks identified in our filings with the Securitiesand Exchange Commission.  We caution you thatthe foregoing list of important factors is not intended to be, and is not,exhaustive.  We do not undertake toupdate any forward-looking statement that may be made from time to time by oron our behalf.

**Resultsof Operations:**

**General**

Our video phone business has not produced significantrevenues to date.  The extent and timing of future revenues for ourbusiness depends on several factors, including the rate of market acceptance ofour products and the degree of competition from similar products.  Wecannot predict to what extent our video phone product will produce revenues, orwhen, or if, we will reach profitability.

On April 28, 2004, we entered into a multi-yearagreement with General Instrument Corporation d/b/a the Connected HomeSolutions Business of Motorola, Inc. (“General Instrument”) for theworldwide development and distribution of the Ojo personal video phone. Thisagreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phoneproducts.  On February 17, 2006, wemutually agreed with General Instrument to end this agreement.  The ending of this agreement immediatelyterminates exclusivity for both parties. In addition to its  role in development and manufacture of Ojo,WorldGate  now has direct responsibilityand control for the advertising, marketing, and distribution of its products.

Under our development and distribution agreement withGeneral Instrument, General Instrument was responsible for the distribution ofour products and for the direct relationship with the distributors, dealers,and other resellers ultimately used to sell the products.  In addition, General Instrument marketed ourproducts and maintained an inventory of our products.  In performing these functions GeneralInstrument carried the associated risks, costs and expenses.  As a result of ending our agreement withGeneral Instrument, we are now directly assuming these responsibilities and theassociated risks, costs and expenses, and this places increased demands on thecash which we have available.  AlthoughGeneral Instrument’s price of our product to its reseller customers included amark-up from its cost of the product from us that was intended to reflect itsrisks, cost and expenses, plus its profit, we will be charging these resellercustomers a lower price and we cannot be assured that the new price willinclude a sufficient mark-up to cover the risks, costs and expenses that arenow our responsibility going forward.

Under its agreement with General Instrument, WorldGatehad been active in marketing and promoting its products, and working withGeneral Instrument to distribute Ojo. WorldGate intends to continue the rolloutof Ojo using many of the same distributors, retailers and service providers andplans to expand distribution to service providers and retailers around theworld.  In addition to direct sales on our web site, we will continue torely upon a distribution organization of dealers, distributors, originalequipment manufacturers, value added resellers, service providers and otherresellers to market and sell our video phone products, many of which will bethe same as those used by General Instrument. To enable our own retail

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distribution efforts we havehired an experienced retail consumer electronics executive to direct ourefforts in this area.  Under itsagreement with General Instrument, WorldGate’s video phone products wererequired to be co-branded with the Ojo brand (which WorldGate continued to own)and the Motorola brand.  As the result ofending our agreement with General Instrument, we will now be dropping theMotorola brand.

General Instrument also maintained the necessaryinfrastructure to handle distribution logistics, including customer ordering,inventory warehousing, billing, customer service, credit and accountsreceivable functions multiple customers. Until February 17, 2006 all of our revenue for the sale of our videophones was derived from General Instrument, a single customer, and there wereminimal administrative costs associated with billing and collecting thisrevenue.  The Company now has multiplecustomers and bears the associated increased administrative costs and risks ofcollection. WorldGate also is in the process of developing the necessaryinfrastructure to handle multiple customers and these other logisticalfunctions.

As part of ending our agreement with GeneralInstrument, and in anticipation of WorldGate inventory requirements as a resultof taking full responsibility for product distribution, WorldGate negotiatedthe right to buy back about two-thirds of the units sold to General Instrument,valued at approximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost the Company to purchase the same inventory from its manufacturingsources.  For more details, refer to Note14 to our condensed consolidated financial statements for the three and ninemonths ended September 30, 2006.

The Company does not believe it is necessary toestablish a reserve for retailer returns to General Instrument.  In the Company’s discussions with theretailers eligible for such returns, the retailers have indicated theirintention to continue to sell the Company’s video phone products and to datethe Company has not received any returned products.

As part of ending the development and distributionagreement, General Instrument has agreed to certain restrictions on itsdevelopment of a stand-alone video phone product which has as a primaryfunction of making or receipt of video phone calls over a broadbandnetwork.  Such restrictions will end in January 2007.

*CriticalAccounting Policies and Estimates.*

Our condensed consolidated financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States.  These generallyaccepted accounting principles require management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates.

Our significant accounting policies are described inthe notes to the consolidated financial statements included in our annualreport on Form 10-K.  Judgments andestimates of uncertainties are required in applying our accounting policies inmany areas.  Following are some of theareas requiring significant judgments and estimates:  revenue recognition, accounts receivable,inventories, cash flow and valuation assumptions in performing asset impairmenttests of long-lived assets, value of redeemable preferred stock, relatedwarrants and conversion options.

Three and NineMonths Ended September 30, 2006 and September 30, 2005.

*Revenues.*

Revenues for the three and nine months ended September30, 2006 were $962 and $1,658, respectively, primarily reflecting the initialproduct revenues from the Company’s direct distribution of the Ojo productsubsequent to the termination of its exclusive distribution agreement with itsformer distributor on February 17, 2006. These revenues represent deliveries ofvideo phones and related service fees. Revenues during the three and ninemonths ended September 30, 2005 were $2,290 and $3,866, respectively, andreflect product inventory build up by the Company’s former distributor.  The reduction in revenue during 2006 withrespect to comparable periods in 2005, primarily reflects the delay in oursales activities as a result of transitioning the reseller network of ourformer distributor and adding incremental direct distribution.  During the quarters ended June 30, 2006 andSeptember 30, 2006 we shipped several thousand units to customers with a rightof return should the units not be sold through to their customer.  Revenue for these units were deferred as ofSeptember 30, 2006 in accordance with FAS 48 “Revenue Recognition when a Rightof Return Exists”.  However, we do expectto begin recording these shipments as revenue as and when these units are soldby our customers.

On March 13, 2006, as an incentive to promote deliveryof the units, the Company announced a special price protection program tocertain retailers and a rebate program to consumers. These incentive programsbegan on April 1, 2006 and

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terminated at the end ofthe second quarter of 2006. Consistent with the EITF Issue 01-9, Accounting forConsideration Given by a Vendor to a Customer, we offset our revenues for thethree and nine months ended September 30, 2006 by $0 and $35 respectively, forthe price protection program and increased revenue $2 and decreased revenue of$22, respectively, for the consumer rebate program for the three and ninemonths ended September 30, 2006.  Formore details, refer to Note 14 to our condensed consolidated financialstatements for the three and nine months ended September 30, 2006.

*Costs andExpenses*.

*Cost ofRevenues*. The cost of revenues, consisting of product and deliverycosts relating to the initial deliveries of video phones, was $894 and $2,076,respectively, for the three and nine months ended September 30, 2006. Costs ofrevenues during the three and nine months ended September 30, 2005 were $2,450and $3,840, respectively.  Included inthese costs for 2006 were inventory adjustments for obsolescence and lowermarket valuations of $0 and $466, respectively. In addition, reduced inventory valuation, freight charges, productrework expenses, reserves for warranty and other costs related to the productfurther  increased  the cost of revenues by $184 and $235,respectively, for the three and nine months ended September 30, 2006.

*Engineeringand Development*. Engineering and development expenses primarily consist of compensation,and the cost of design, programming, testing, documentation and support of theCompany’s video phone product. Engineering and development costs were $1,507 for the three months endedSeptember 30, 2006, compared with $1,242 for the three months ended September30, 2005.  For the nine months endedSeptember 30, 2006 and 2005, such costs were $4,501 and $3,666,respectively.  These increases of $265,or 21%, for the three months ended September 30, 2006, and $835, or 23%, forthe nine months ended September 30, 2006, reflects the Company’s increasedconcentration of its engineering staff, and related costs, for the further andcontinuing development of its video phone product.

*Sales andMarketing*.  Sales andmarketing expenses consist primarily of compensation (which includescompensation to manufacturer’s representatives and distributors), attendance atconferences and trade shows, travel costs, advertising, promotions and othermarketing programs (which includes expenditures for co-op advertising and newmarket development) related to the continued introduction of the Company’svideo phone product.  Sales and marketingcosts were $619 for the three months ended September 30, 2006, compared with$392 for the three months ended September 30, 2005.  Sales and marketing costs were $1,820 for thenine months ended September 30, 2006, compared with $1,410 for the nine monthsended September 30, 2005. This increase of $227, or 58%, for the three monthsended September 30, 2006, and the increase of $410, or 29%, for the nine monthsended September 30, 2006, reflects the increased staff, advertising and relatedmarketing and promotional expenditures associated with the Company’s videophone product.

*Generaland Administrative*. General and administrative expenses consist primarily of expendituresfor administration, office and facility operations, finance and generalmanagement activities, including legal, accounting and professional fees.  General and administrative expenses were$1,205 for the three months ended September 30, 2006, compared with $1,474 forthe three months ended September 30, 2005. These same expenses were $5,573 forthe nine months ended September 30, 2006, compared with $3,462 for the ninemonths ended September 30, 2005. This decreases of $269, or 18%, for the threemonths ended September 30, 2006 is primarily attributable to reducedexpenditures during the third quarter of 2006 for financial and legal fees of$260.  Other non-cash expenditures increasedby $199 in the third quarter of 2006 relating to the Company’s stock basedemployee compensation plans (see additional information below), with anoffsetting reversal of accruals of  $139for certain penalties associated with a previous financing that are no longerdue.  For the nine months ended September30, 2006, the increase of $2,111, or 61%, was primarily attributable to certainexpenses incurred during the  nine monthsended September 30, 2006 that were not incurred during the three and nine monthsended September 30, 2005, including a non cash charge of $615 from the Company’sadoption of the fair value recognition provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS123(R)”), using the modified-prospective-transition method.  Prior to January 1, 2006, the Company’sstock-based employee compensation plans were accounted for under therecognition and measurement provisions of Accounting Principles Board Opinion “APBNo. 25, and related Interpretations, as permitted by Financial AccountingStandards Board (“FASB”) Statement No. 123, “Accounting for Stock-BasedCompensation,” (“SFAS 123”). The Company did not recognize stock-based employeecompensation cost in its statement of operations for periods prior to January1, 2006 as all options granted had an exercise price equal to the market valueof the underlying common stock on the date of grant (for more details, refer toNote 7 to our condensed consolidated financial statements for the three andnine months ended September 30, 2006.) In addition, this increase reflects $1,387 for the  nine months endedSeptember 30, 2006 of accrued penalties related to the private placement inAugust 2005 (for more details, refer to Note 3 to our condensed consolidatedfinancial statements for the three and nine months ended September 30,2006).  Furthermore, this increase forthe nine months ended September 30, 2006 includes legal, accounting andauditing fees of $194 in excess of fees incurred in the same periods of2005.  These increased fees include $144of fees associated with its Sarbanes-Oxley internal control complianceimplementation for 2005 and restatements of prior filings with the Securitiesand

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ExchangeCommission.  In addition, rent expenseincreased by $42 for the nine months ended September 30, 2006 over the sameperiod in 2005.

*Interestand Other Income and Interest Expense*.  Interest and other income consist of interestearned on cash and cash equivalents. Interest expense of $50 consist of accruedinterest on the convertible debentures issued on August 11, 2006 (see Note 9 toour condensed consolidated financial statements for the three and nine monthsended September 30, 2006).  Interest andother income decreased from $292 for the three months ended September 30, 2005to $90 for the three months ended September 30, 2006 and from $466 for the ninemonths ended September 30, 2005 to $323 for the nine months ended September 30,2006, primarily due to lower average levels of invested funds during the threeand nine months of 2006 compared to the same periods in 2005.  During the three and nine months endedSeptember 30, 2006, the Company earned interest on average cash balances ofapproximately $7,559 and $10,131, respectively. In comparison, during the threeand nine months ended September 30, 2005 the Company earned interest on averagecash balances of approximately $14,770 and $12,111, respectively.  There was $50 of accrued interest expenserecorded for the three and nine months ended September 30, 2006 relating to theconvertible debentures.

*Income Taxes*.  The Company has incurred netoperating losses since inception and accordingly had no income taxes and hasnot recorded any income tax benefit for those losses, since realization of suchbenefit is currently uncertain.

*NonCash Change in Fair Value of Derivative Warrants and Conversion Options.*For the three months ended September 30, 2006 the non cash change in fairvalue of derivative warrants and conversion options was a gain of $17.  For the three months ended September 30,2005 the non cash change in fair value of derivative warrants and conversionoptions was income of $1,165. For the nine months ended September 30, 2006the non cash change in fair value of derivative warrants and conversion optionswas a loss of $322.  For the nine monthsended September 30, 2005 the non cash change in fair value of  derivative warrants and conversion optionswas income of $7,974. These marked to market adjustments are primarily a resultof changes in our common stock price at each reporting period related to ourJune 24, 2004 private placement of our Series A Convertible Preferred Stock andWarrants and our August 11, 2006 private placement of secured ConvertibleDebentures and Warrants.

*Amortizationof Debt Discount*.  Forthe three and nine months ended September 30, 2006 the amortization of the debtdiscount was $201, relating to the August 11, 2006 private placement of securedConvertible Debentures.  This discount,at the time of completion of this private placement on August 11, 2006, wasinitially recorded for $4,446, and will be amortized using  the effective interest rate method over thethree year term of the convertible debentures (see Note 9 to our condensedconsolidated financial statements for the three and nine months ended September30, 2006).

Liquidity andCapital Resources.

As of September 30, 2006, our primary source ofliquidity consisted of cash and cash equivalents that are highly liquid, are ofhigh quality investment grade and have original maturities of less than threemonths.

At September 30, 2006, we had cash and cashequivalents of $8,147 as compared to cash and equivalents of $16,277 atDecember 31, 2005. Net cash used in operating activities was $4,629 and$13,437, respectively, for the three and nine months ended September 30,2006, as compared to $2,488 and $8,410, respectively used for the same periodsin 2005. The increase in net cash used in operating activities was primarilyattributable to our increase in expenditures during the three and nine months endedSeptember 30, 2006 compared to the same periods in 2005, related primarilyto an increase in staffing of approximately $223 and $1,118, respectively,increased expenditures relating to certain legal settlements of $345 in thethird quarter of 2006, a $480 expenditure during the first quarter of 2006 forrepurchased products previously sold to General Instrument totaling $1,064,which included the offset of $584 of accounts receivables due the Company,and  increased payments of operatingpayables and accrued expenditures by $1,016 and $2,792, respectively, for thethree and nine months ended September 30, 2006 over the same periods in2005.  No bad debt expense was recordedfor the three and nine months ended September 30, 2006 and 2005.

Cash used for investing activities were primarily aresult of investments in equipment for product development and manufacture aswell as for general administrative purposes. For the three month periods ending September 30, 2006 and 2005, suchinvestments were $77 and $106, respectively. For the nine month periods ending September 30, 2006 and 2005, suchinvestments were $327 and $428, respectively.

Cash provided by financing activities primarily aresult of various private placements of our Company’s securities, the issuanceof convertible debt,  the exercise ofwarrants and the exercise of non-executive employees’ and prior employees’stock options during the three months ended September 30, 2006.  Total cash provided by financing activitieswas $5,622 compared

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to $16,965 during thesame period in 2005.  For the nine monthsended September 30, 2006, cash provided by financing activities totaled$5,634 compared to $18,889 provided during the same period in 2005.

Operations and Liquidity.

To date, we have funded operations primarily throughmultiple private sales of equity securities, through the issuance ofconvertible debentures and through an initial public offering of common stockin April 1999. The financing secured on August 11, 2006 (see Note 3 to ourcondensed consolidated financial statements for the three and nine months endedSeptember 30, 2006)  has added long termdebt to the balance sheet and the Company has pledged its asset as collateral.  We continue to evaluate the possibilities toobtain further additional financing through public or private equity or debtofferings, bank debt financing, asset securitizations, or from other sources.Such additional financing would be subject to the risk of availability, may bedilutive to our stockholders, or could impose restrictions on operatingactivities. There can be no assurance that this additional financing will beavailable on terms acceptable to us, if at all.

The report of the independent registered publicaccounting firm for the year ended December 31, 2005 includes anexplanatory paragraph stating that our Company had suffered recurring lossesfrom operations and had an accumulated deficit of $229,092, and that theseissues raised substantial doubt about our Company’s ability to continue as agoing concern. Our short term cash requirements and obligations includeinventory, accounts payable and capital expenditures from continuingoperations, operating expenses, and the redemption of preferred stock, of which$166 is required to be redeemed in June 2007, although this redemption canbe made in common stock if certain conditions are met.  In addition, the August 2005 privateplacement includes cash payment penalties of 1.5% per month for the period thatthe shares in the transaction fail to be registered. The Registration Statementcovering the shares under this private placement was not declared effectiveuntil June 1, 2006.  Until such time asthe shares were registered the Company was subject to the penalty provisionunder this private placement. For the three months ended September 30, 2006 and2005 the Company recorded and expensed related penalties of $0 and $0,respectively.  For the nine months endedSeptember 30, 2006 and 2005 the Company recorded and expensed related penaltiesof $1,248 and $0, respectively. The related unpaid penalties accrued as ofSeptember 30, 2006 and December 31, 2005 were $472 and $525, respectively.  On July 25, 2006, the Company amended theterms of the additional investment right that was granted to an investor aspart of the August 2005 private placement, with respect to a portion of sharesof common stock purchasable thereunder and agreed to apply $158 of accruedpenalties towards the exercise price of such amended additional investmentright, for the purchase of 129,950 shares of common stock. The penalties hadaccrued with respect to the Company’s inability to register the shares acquiredby such investor in the private placement within 120 days of thetransaction.  In consideration for thisamendment and application of the exercise proceeds the investor agreed toforego any cash payment of the penalties other than as available through theproceeds of the exercise of the amended investment right and to grant to theCompany a release of all claims relating to the late registration of theprivate placement shares, other than the aforesaid penalties.  The amendedadditional investment right provides that the investor thereof may purchase the129,950 shares of common stock for a period of 760 days beginning June 1, 2006for an exercise price of $1.515 per share.  The terms of the additionalinvestment rights with respect to the remaining 1,424,050 shares of commonstock purchasable thereunder remain unchanged. On July 26, 2006 this investor exercised the additional investment rightfor 129,950 shares.  On July 31,2006 the amended additional investment right with respect to the remaining1,424,050 shares of common stock expired. The ending of the General Instrument agreement on February 17, 2006places additional cash burdens on the Company and this could impact our cashrequirements and usage.  As part ofending its agreement with General Instrument, and in anticipation of WorldGateinventory requirements as a result of taking full responsibility for productdistribution, WorldGate negotiated the right to buy back about two-thirds ofthe units sold to General Instrument, valued at approximately $2,765 (basedupon the original sales price to General Instrument), for approximately $1,064.This is less than half of what it would cost the Company to purchase the sameinventory from its manufacturing sources. For more details, refer to Note 14 to our condensed consolidatedfinancial statements for the three and nine months ended September 30, 2006.

Management expects, based on our internal forecastsand assumptions including among others, assumptions regarding our short termcash requirements and our projected revenue growth, and including the fullfunding of $11,000 from the August 11, 2006 transaction completed subsequent tostockholder approval received on October 11, 2006, that we have sufficient cashon hand to meet our obligations into the second half of 2007.

Our ability to generate cash is dependent upon thesale of our Ojo product and on obtaining cash through capital markets.  Webegan generating revenue from commercial shipment of our Ojo product in April2005 and we expect revenues to increase as the product continues to roll out tothe marketplace. Depending on the ramp up of sales and the achievable margins,the increased level of sales activity should have a positive impact on our cashflows from operations, which will support our ability to meet our cashrequirements in the long term. Given that our video phone business involves thedevelopment of a new

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product line with no marketpenetration, in an underdeveloped market sector, no assurances can be giventhat sufficient sales, if any, will materialize.

We, however, remain hopeful that sufficient sales willmaterialize and/or that sufficient funding can be developed through ongoingoperations or further additional financings to continue our operations beyond2007.

Our long term cash requirement obligations areprimarily comprised of the items noted above. We have long term debt on thebalance sheet as of September 30, 2006 from the financing secured on August 11,2006 (see Note 3 to our condensed consolidated financial statements for thethree and nine months ended September 30, 2006).  We have limited capacityto reduce our workforce and scale back on capital and operational expendituresto decrease our cash usage.

ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.

Interest Rate Risk. Our exposure to market risk related to changes in interest rates relatesprimarily to our investment portfolio. We invest in instruments that meet high credit quality standards, and welimit the amount of credit exposure with respect to any one issue, issuer andtype of investment.

As of September 30, 2006, the Company’s cash and cashequivalents were $8,147, which were comprised of securities having a maturityof less than three months.  Due to theaverage maturity and conservative nature of our investment portfolio,management believes a sudden change in interest rates would not have a materialeffect on the value of the portfolio. Manage­ment estimates that had theaverage yield of our investments decreased by 100 basis points, our interestincome for the nine months ended September 30, 2006 would have decreased byapproximately $92. This estimate assumes that the decrease occurred on thefirst day of 2006 and reduced the yield of each investment instrument by 100basis points.  The impact on our futureinterest income of future changes in investment yields will depend largely onour total investments.

Foreign Currency Exchange Risk.  Although we transact business in variousforeign countries substantially all of our revenues and costs to date have beendenominated in U.S. dollars.  Althoughour agreement with Mototech, Inc. (not an affiliate of General Instruments orMotorola), our contract manufacturer in Taiwan, is denominated in U.S. dollars,their material acquisition costs are subject to exchange rate changes thatcould impact our product costs.

# ITEM 4.   CONTROLS AND PROCEDURES.

Disclosure Controls and Procedures. We maintaindisclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)and 15d-15(e)) that are designed to ensure that information required to bedisclosed in reports that we file or submit under the Securities Exchange Actof 1934 is recorded, processed, summarized, and reported within the timeperiods specified in the Securities and Exchange Commission’s rules and forms,and that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding the required disclosures. Indesigning and evaluating the disclosure controls and procedures, we recognizethat any controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired control objectives.

We carried out an evaluation, under the supervisionand with the participation of management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures as of September 30, 2006.  Our Chief Executive Officer and ChiefFinancial Officer determined that we have a material weakness (as defined underthe standards established by the Public Company Accounting Oversight Board)that exists with respect to our control procedure for the accounting andreporting of complex financial transactions.

As previously reported in our Form 10-K for the yearended December 31, 2005, we identified material weaknesses in our controlprocedure for the accounting and reporting of complex financial transactions.These material weaknesses contributed to restatements of our financialstatements in our annual and quarterly reports from the quarter ended March 31,2004 through September 30, 2005.

To address this material weakness, we have engagedoutside experts to provide counsel and guidance in areas where we cannoteconomically maintain the required expertise internally (e.g., with theappropriate classifications and treatments of complex and non-routinetransactions).

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As a result of the material weakness identified withrespect to our control procedures for the accounting and reporting of complextransactions, the Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are not designed and are noteffective in ensuring that the information required to be disclosed by ourCompany in the reports that we file and submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the Commission’s rules and forms.  Except as identified above, therehave been no changes in our internal control over financial reporting thatoccurred during the quarter ended September 30, 2006, that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

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**PART II.OTHER INFORMATION**

# ITEM 1.   LEGAL PROCEEDINGS.

None.

# ITEM 1A  RISK FACTORS.

The following sets forth material changes to the riskfactors we previously disclosed in our annual report on Form 10-K for thefiscal year ended December 31, 2005 (the “2005 Form 10-K”) in response to Item1A of Form 10-K. In addition to other information in this Form 10-Q and the2005 Form 10-K, the following risk factors should be carefully consideredin evaluating our company and our business. Investing in our common stockinvolves a high degree of risk, and you should be able to bear the completeloss of your investment. We also caution you that this Form 10-Q and the 2005Form 10-K include forward-looking statements that are based on management’sbeliefs and assumptions and on information currently available to management.Future events and circumstances and our actual results could differ materiallyfrom those projected in any forward-looking statements. You should carefullyconsider the risks described below, the other information in this Form 10-Q,the 2005 Form 10-K, the documents incorporated by reference therein andthe risk factors discussed in our other filings with the Securities andExchange Commission when evaluating our company and our business. The risks anduncertainties described below and in the 2005 Form 10-K are not the only oneswe face. Additional risks and uncertainties not presently known by us or thatwe currently deem immaterial also may impair our business operations. Ifany of the following risks actually occur, our business could be harmed. Insuch case, the trading price of our common stock could decline and investorscould lose all or part of the money paid to buy our common stock.

**Effectof the Secured Convertible Debenture**

**Thesecured convertible debentures and warrants may have an adverse impact onthe market value of our common stock.**

The sale of stock issuable upon conversion of thesecured convertible debentures and upon exercise of the warrants issued orissuable in connection with our August 11, 2006 private placement and thesubsequent closing thereunder on October 13, 2006, or even the possibility oftheir sale, may adversely affect the trading market for our common stockand adversely affect the prevailing market price of our common stock.

The existence of rights under such debentures andwarrants to acquire our common stock at fixed prices may prove a hindranceto our efforts to raise future equity and debt funding, and the exercise ofsuch rights will dilute the percentage ownership interest of our stockholdersand may dilute the value of their ownership.

**Thesecured convertible debentures and warrants may adversely affect ourfinancial flexibility.**

The secured convertible debentures impose asignificant debt burden on us that could have adverse consequences on ourbusiness. The amount of the debentures could adversely affect us in anumber of ways, including the following:

·                  we may be unable toobtain additional  financing  for workingcapital, capital  expenditures,acquisitions and general corporate purposes;

·                  debt-service requirements couldreduce the amount of cash we have available for other purposes;

·                  we may  be  restricted in our ability tomake strategic acquisitions and to exploit business opportunities; and

·                  we may be required to make cashpayments under the terms of the debentures which would reduce the amount ofcash we have available for other purposes.

Our ability to make payments of principal and intereston our debt, whether in cash or shares of our common stock, depends upon ourfuture performance, general economic conditions and financial, business andother factors affecting

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our operations, manyof which are beyond our control.  If we are not able tomake these payments with shares of our common stock or generate sufficient cashflow from operations in the future to service our debt we may be required,among other things:

·                  to seek additional financing in thedebt or equity markets;

·                  to refinance or restructure all or aportion of our debt; or

·                  to sell assets.

These measures might not be sufficient toenable us to service our debt.  In  addition, anysuch  financing, refinancing or sale of assets might not beavailable on economically favorable terms.

**Thesecured convertible debentures and warrants may adversely affect ouroperational flexibility.**

The terms of the August 11, 2006 private placementimpose restrictions on us that may affect our ability to successfullyoperate our business.  The transaction documents contain a number ofcovenants that may restrict our ability to operate, including, among otherthings, covenants that restrict our ability:

·                  to incur additional indebtedness;

·                  to pay dividends on our capital stock(except for our preferred stock);

·                  to redeem or repurchase our commonstock;

·                  to issue shares of common stock, orsecurities convertible into common stock;

·                  to use our assets as security inother transactions;

·                  to create liens on our assets; and

·                  to enter into certain transactionswith affiliates.

Further, the debentures limit our ability to enterinto change of control transactions by providing that any such transactioncould constitute an event of default with respect to the debentures.  Anevent of default could result in acceleration of our indebtedness and permitthe investor to foreclose on our assets.

# ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS.

As disclosed in our quarterly report on Form 10-Q forthe quarterly period ended June 30, 2006, we entered into a purchase agreementwith an institutional investor on August 11, 2006, providing for the issuanceof convertible debentures in an aggregate principal amount of up to$11,000,000. As part of the initial closing thereunder, on August 11, 2006 weissued a convertible debenture in the principal amount of $6,000,000 to theinvestor (we received $5,600,000 net of deal costs).  The purchase agreementprovided for the issuance of additional convertible debentures in an aggregateprincipal amount of $5,000,000 subject to certain conditions precedent,including stockholder approval of the deal and registration of a portion of theshares of common stock issuable in the transaction. As disclosed in our currentreport on Form 8-K filed on October 19, 2006, these conditions precedent weresatisfied and. on October 13, 2006, we completed the subsequent closing underthe purchase agreement and, in connection therewith, we issued a convertibledebenture to the investor in the principal amount of the remaining $5,000,000(we received $4,700,000 net of deal costs).

These convertible debentures have a maturity of threeyears, an interest rate of 6% per annum, and are convertible at the option ofthe investor into our common stock at a conversion price equal to the lesser of$1.75 per share or 90% of the average of the five lowest daily volume weightedaverage closing price (“VWAP”) of the common stock during the fifteen tradingdays immediately preceding the conversion date (subject to adjustment in theevent of stock dividends and splits and certain distributions to stockholders,fundamental transactions, and future dilutive equity transactions).  Interest is payable at maturity, and we mayelect to pay the interest amount in cash or shares of our common stock.

As part of these private placements, we issued to theinvestor five-year warrants to purchase a total of up to 2,595,000 shares ofour common stock, with 1,145,000 of the warrants having an exercise price of$1.85 per share (with 624,545 of these warrants issued at  the initial closing and 520,455 issued at thesubsequent closing), 1,100,000 of the shares having an exercise price of $2.35per share (with 600,000 of these warrants issued at the initial closing and500,000 issued at the subsequent closing), and 350,000 warrants having anexercise price of $2.60 per share (with 190,909 of these warrants issued at theinitial 

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closing and 159,091issued at the subsequent closing). As part of the initial closing, we alsoissued to the investor 177,419 shares of our common stock.

The convertible debentures provide that we have theright to redeem all or any portion of the principal amount of the debentures incash at any time upon not less than four business days notice if the closingprice of our stock is less than $1.75 per share. Such early redemption will,however, require us to pay a 10% prepayment premium. In addition, without anyprepayment premium, we have the right to force the holder to convert a maximumof $500,000 of the aggregate principal amount of the debentures in any thirtyday period if for five consecutive trading days the VWAP of our common stock isabove $1.925 per share but less then $3.50 per share and providing the dailytrading volume exceeds 200,000 shares for these five days, and certain otherconditions are met. If the VWAP of our common stock is greater than $3.50per share for 30 consecutive trading days, the daily trading volume exceeds 250,000shares for five days prior, and if certain other conditions are met, we canalso force the holder to convert all or any portion of the outstandingprincipal and interest into shares of our common stock without any prepaymentpremium.

There are some restrictions on the holder’s right toconvert the debentures.  The holder cannot make any conversions below$1.75 per share (i) until the earlier of the date registered common stock canbe issued pursuant to such conversion or January 1, 2007, (ii) which would exceed$500,000 in aggregate principal amount in any calendar month, or (iii) whichwould result in the issuance of more than 840,000 shares of our common stockper calendar month in the aggregate (provided that this maximum share limitwill be waived by us unless we elect to pay the holder in cash the differencein value between 840,000 shares and the number of shares the holder wishes toconvert, up to the $500,000 per month conversion limit).  If we are indefault under the debentures these limitations are waived. The holder is alsonot restricted in making conversions at $1.75. In no case, however, may theholder convert the debentures if (x) it would result in beneficial ownership ofmore than 9.99% of our outstanding common stock (though this provision can bewaived by the holder upon 65 days prior notice), or (y) such conversion would,without stockholder approval, cause us to issue more than 19.99% of ouroutstanding shares as determined immediately prior to consummation of thetransaction.  Under certain circumstances, the debentures holder isentitled to have the conversion price adjusted to correspond to common stockholders’ rights to any stock dividend, stock split, stock combination orreclassification of shares. The $1.75 conversion price is also subject to aweighted average dilution adjustment if we issue shares (apart from certainexcluded issuances) of our capital stock at an effective price of less than$1.75 per share.  We also granted the debentures holder a securityinterest in all of our assets.

The aggregate number of shares that may be issued inconnection with the private placements, including the shares issued at theinitial closing, and the shares issuable upon conversion of the debentures,exercise of the warrants, and payment of liquidating damages pursuant to theregistration rights agreement, has been limited to 61,111,111 shares of commonstock.

The shares issued at the initial closing, theconvertible debentures and the warrants were issued in reliance upon theexemption from the registration requirements of the Securities Act of 1933afforded to transactions not involving a public offering by Section 4(2) ofthat Act and Rule 506 thereunder.

# ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

None.

# ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.

None.

# ITEM 5.  OTHER INFORMATION.

None.

ITEM 6.  EXHIBITS.

The following is a list of exhibits filed as part ofthis report on Form 10-Q.  Where soindicated by footnote, exhibits that were previously filed are incorporated byreference.  For exhibits incorporated byreference, the location of the exhibit in the previous filing is indicatedparenthetically except in those situations where the exhibit number was thesame as set forth below.

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| Exhibit | ** ** | **Description**                                                                                                                                                                |
|---------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |       |                                                                                                                                                                           |
| 3.1     |       | Amended and Restated Certificate of Incorporation  (3)                                                                                                                         |
| 3.2     |       | Amended and Restated Bylaws (1)                                                                                                                                                |
| 3.3     |       | Certificate of Amendment to Certificate of  Incorporation, dated October 18, 2004 (3)                                                                                          |
| 3.4     |       | Certificate of Designations, Preferences and Rights  of the Series A Convertible Preferred Stock of the Company dated June 23,  2004 (2)                                       |
| 4.1     |       | Securities Purchase Agreement, dated as of August  11, 2006, by and among the Company and Cornell Capital Partners,  LP (4)                                                    |
| 4.2     |       | Investor Registration Rights Agreement, dated August  11, 2006, by and among the Company and Cornell Capital Partners,  LP (4)                                                 |
| 4.3     |       | Form of Secured Convertible Debenture issuable by  the Company to Cornell Capital Partners, LP pursuant to the Securities  Purchase Agreement, dated as of August 11, 2006 (4) |
| 31.1    |       | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a)*                                                                                                          |
| 31.2    |       | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a)*                                                                                                          |
| 32.1    |       | Certification of Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act  of 2002*                                    |
| 32.2    |       | Certification of Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act  of 2002*                                    |

 

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* Filed herewith

(1) Incorporated by reference to the exhibits to our Form 10-QReport for the quarter ended March 31, 1999.

(2) Incorporated by reference to the exhibits to our Form 8-K CurrentReport filed on June 25, 2004 (Exhibit 3.1).

(3) Incorporated by reference to the exhibits to our Form 10-QReport for the quarter ended September 30, 2004 as filed on November 17, 2004.

(4) Incorporated byreference to the exhibits to our Form 10-Q Report for the quarter endedJune 30, 2006 as filed on August 14, 2006.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|        |             | WORLDGATE COMMUNICATIONS, INC.                |
|--------|------------------|-----------------------------------------------|
|   |             |                                          |
|   |             |                                          |
| Date:  | November 9, 2006 |                                          | /s/ Hal M.  Krisbergh |   |
|   |             | Hal M. Krisbergh                              |
|   |             | Chairman and Chief Executive Officer          |
|   |             | (Principal  Executive Officer)                |
|   |             |                                          |
|   |             |                                          |
| Date:  | November 9, 2006 |                                          | /s/ Joel  Boyarski |   |
|   |             | Joel Boyarski                                 |
|   |             | Vice President and Chief Financial Officer    |
|   |             | (Principal  Financial and Accounting Officer) |

 

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